When we wrote about small cap stocks in June 2011, we concluded that they faced a number of headwinds and were unlikely to continue their strong outperformance versus large caps that began in 2000. This outlook was strongly supported by relative valuations versus large caps that were at/near 20+ year highs on multiple metrics. This view proved correct up until 2013 when small caps went on an absolute tear, becoming even more overvalued and outperforming large caps by a wide margin, extending the small cap relative bull market to 13 years. However, small caps have underperformed large caps notably since the beginning of 2014. The performance ratio of small caps relative to large caps reached its lowest level since December 2009 in mid-October and has not rebounded much since.
Despite the relative underperformance versus large caps in 2014, this group of stocks remains at historically elevated absolute and relative valuations. Today's valuations combined with the fact that the U.S. economy is well into the middle phase of the economic expansion, suggest an underweight allocation to smaller cap stocks remains appropriate.
Small Cap Fundamentals and the Business Cycle
Stocks of smaller companies historically have demonstrated a tendency to outperform larger firms early in the business cycle and lag in the later innings. This performance pattern is attributable to small caps generally being more economically sensitive and more reliant on financing conditions than larger companies. Larger cap companies are typically big, sometimes multi-national, stable companies with slower growth profiles that are likely at or near the mature phase of growth. There are exceptions within each category, but as a whole, large cap companies are more likely to exhibit stronger fundamentals and also have an easier time raising funds if necessary than smaller cap companies. They tend to have more stable sales, higher cash flow, and more stable and wider margins, which help cushion slowdowns in economic activity.
The economic cycle is well past the early expansion phase when small caps historically shine the brightest. According to Manning & Napier's Economic Clock, the U.S. economy is currently in the late expansion phase of the business cycle. Though not a terrible environment for small caps on an absolute basis, there is a strong tendency to underperform large caps.
The historical track record for small caps versus large caps is not exceptional at this point in the business cycle; however, there are potential positive catalysts to be monitored. Smaller companies are positioned well for strengthening of domestic demand,while lower gasoline prices as well as increased payroll and wage growth should help spur further demand growth. Smaller companies will also benefit from easier access to bank credit. Furthermore, operating margins for small cap companies remain off their peak levels whereas large cap margins are near or above their historical highs. This suggests opportunities may remain for small cap companies to continue expanding their margins, an area of potential earnings growth.
On the negative side, small caps today tend to be highly leveraged, which could partially explain their underperformance in 2014. Small cap companies had leverage ratios similar to, or above, their large cap neighbors in the Energy, Consumer Staples, and Telecommunication Services sectors. Additionally, small caps' interest coverage ratios relative to large caps have been decreasing since 2006, hitting their lowest levels since the mid-80s earlier in 2014. Increasing interest rates could make the ratio even worse, especially because smaller companies are more likely to have floating rate bank loans or shorter duration bonds which would force them to refinance at higher rates.
Valuations Far from Compelling
Stock valuations are an imprecise timing tool over the short-term, but over time they can provide powerful signals as to the potential for future returns. Small cap valuations today are elevated both on an absolute and relative basis, leaving little to no room for error. Though they are off their most expensive highs, small caps are not cheap by any means and by most metrics are still very expensive. We believe that it is important to be selective when choosing stocks from this universe. While they may not be headed for a severe correction today, they are unlikely to see multiple expansions at this juncture. Present valuations should require earnings growth moving forward for companies to be rewarded. Many small cap stock prices are likely to remain range-bound as earnings grow into multiples. Being more exposed to the U.S. is a positive, but with expectations regarding the aforementioned drivers of domestic demand growth already priced into these particular stocks, the risk side of the risk-reward tradeoff is heightened, while the reward side is dampened.
What Does This Mean?
The weight of the evidence suggests that continued underperformance of small caps in 2015 is likely. This evidence includes both valuations and where the U.S. is in the economic cycle. While our indicators do not suggest that a sustained bear market is probable at this point, future bouts of market volatility are expected. Small caps may be punished more severely in a correction, given they are perceived as less defensive and because they are expensive today in absolute terms as well as relative to large caps. This does not mean that small caps should be avoided entirely. Opportunities do remain, but in the current environment it is important to focus on those companies that have compelling underlying fundamentals coupled with attractive valuations.