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Why We Are Bullish Small Caps

May 03, 2020 12:00 PM ETIJR, IWM, VB, VBK, VBR11 Comments
Ben Laidler profile picture
Ben Laidler


  • US small cap has lagged large cap, given concerns on its high leverage, cyclical index composition, and domestic focus.
  • Yet, valuation premium at decade low, earnings revisions no worse than large cap, Fed intervening in HY, IT/Healthcare the two largest sectors, and small cap traditionally led in the recovery.
  • Small cap, real estate, and Europe are our select cyclical recovery allocations with best risk/reward.

Small cap lagged a lot

We believe the risk/reward for US small caps is attractive, as relative valuations are at decade lows, Fed intervention in the high-yield credit market limits downside risks, and small cap has significantly outperformed in prior market recoveries, helped by its more cyclical and domestic index composition.

US small cap lagged by a dramatic 14pp YTD in the crash versus large cap and lagged for the year preceding the crash. Small-cap underperformance was much greater than the c3pp lag in the 2007-9 bear market, whilst small cap significantly outperformed during the 2000-2 market crash. This recent underperformance is also in contrast to its longer-term outperformance record, with the MSCI US small cap having an average annual 15-year 12.3% return versus 11.2% for US large caps.

Small Cap price performance

Valuation premium almost disappeared

The small-cap 12-month forward P/E ratio is 20.5x, a 9% premium to the large-cap index on 18.8x. This is by far the lowest relative premium of the last decade and compares to the 10-year average 33%. This premium has been declining, most notably in the last two years, as interest rates rose, GDP growth decelerated, and big tech outperformance accelerated.

Small cap valuation

Three drivers of small-cap underperformance

We focus on what we see as the three recent drivers of small -cap underperformance: leverage, sector composition, domestic focus

1) Leverage is higher. HY market key

We believe investors have focused on the higher small-cap leverage, and the correlation with high-yield bond markets, as recession and earnings fears have built. Eight of ten small-cap, non-financial sectors have higher relative leverage, with consumer discretionary and utilities the only exceptions. High-yield spreads have soared, but crucially are much lower now than in the global financial crisis and even below levels seen in 2016, whilst we are now seeing unprecedented Fed primary and secondary market

This article was written by

Ben Laidler profile picture
Ben Laidler, CEO of Tower Hudson Research, and publisher of the daily 'Eye on the World' investment report. He has over 25 years global investment research experience, on both the buy and sell-side. Most recently Ben was Global Equity Strategist, Head of Global Equity Sector Research, and Head of Americas Research, at HSBC in New York. Previously he worked at JP Morgan, UBS, and Rothschild Asset Management, in New York, London, and Santiago. He is a regular contributor to Bloomberg, CNBC, Financial Times, New York Times etc.

Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

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Comments (11)

Ben Laidler profile picture
Interesting points below, thanks! If use the MSCI indices as a proxy, there are 630 US large caps (c85% of market cap) in US index, but over 1,700 small caps (the remaining 15% of market cap). This huge universe can be distorted by the average...by company count, a greater percentage of small caps pay dividends, and have net cash, than large caps
Chris Valley profile picture
I am very bullish on small caps with great financial positions.

There's actually tons of them.
PaperChaseMace profile picture
I’ve always been a fan of the small cap markets there’s always more BANG for your Bucks no matter what the situation is...
I Guarantee Warren Buffet not buying those trashy small caps.
Many of them will go away.
yeah, like he bought the airlines. smart move Warren
Small caps about to get slammed. Not enough cash.
Matt GV profile picture
Thanks, excellent article.
Sanjay John profile picture
Agree. Long IWM via options. Hoping for massive rally for next 18 months.
I'll take the other side of that trade
And you will lose on that side, buying significantly over valued large caps heavily manipulated by buy backs. Good luck.
How about keeping one foot on each side. Thats what I have been doing. Smaller portion allocated to small caps vs large caps.
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