- 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.
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.
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 support.
2) Index composition more cyclical
Small cap is more cyclical than large cap on our calculations, and therefore more exposed to a weakening economy. The two biggest relative sector weight differences on an overall market cap basis between small cap and large cap is the underweight of IT and large overweight of Financials. This has especially hurt so far this year, with IT the second best-performing large-cap sector, and Financials the second worst performer. Except for Healthcare, the small-cap relative weights are more focused on traditionally cyclical sectors.
This also affects valuation and flatters small cap. On a sector neutral valuation - weighting both indices by the large-cap sector weights to compare better - we calculate the overall small-cap valuation rises to 22.5x P/E, up 10% versus its unadjusted.
However, despite the significant relative weight differences, it is worth remembering that tech (17% weight) and healthcare (16% weight) are still the largest absolute index weights of the MSCI USA Small Cap Index, the broadest of the three main index families analysed here. We are overweight both the large-cap IT and Healthcare sectors. For background see our recent articles on FAANGM and Healthcare.
3. Small cap is more domestic
Small cap is also significantly more domestically focused than large cap. The large-cap overseas revenues are c30% of total versus only c21% for the small-cap MSCI indices. This was arguably a disadvantage coming into this crisis, with the US set to see one of the largest GDP slowdowns globally. Though this may be mitigated in the eventual economic recovery given the dramatic relative US policy response, with 14%/GDP fiscal stimulus and unlimited quantitative easing (QE).
The case for small cap?
Likely to outperform in a rebound
Small cap dramatically outperformed in the 12 months from the US market trough in 2002 despite outperforming in the prior crash and in 2009 by over 25pp, the best of the main factors.
Growth remains similar
Small-cap 10-year average EPS growth is near 20% versus 11% for large cap. The relative outlook is currently more mundane, with both forecast to see 0 to -5% on a 12-month forward EPS basis, and with relative earnings revision ratios similarly bad for both small and large.
Factor tilts to value vs. quality and volatility
The MSCI US small cap index is moderately overweight the value factor (relatively inexpensive stocks) whilst meaningfully underweight the quality (sound balance sheets) and low volatility (lower risk) stocks. It is only modestly underweight momentum and dividend yield factors.
What is small cap anyway?
Small-cap definitions vary significantly and impact both performance and index weights. The MSCI Small Cap definition is the bottom 15% of investable market cap. This gives the largest US small cap a cUS$11bn market cap. By contrast, FTSE Russell focuses on the bottom 10% of the market, with the largest stock having a cUS$5bn market cap. Finally, the S&P 600 index is focused on the bottom 3% of the market, with the largest stock market cap at cUS$4.4bn.
Ways to invest
The largest and broadest US small-cap ETFs are the iShares Core S&P Small Cap ETF (IJR) with a cUS$33bn size, the FTSE Russell 2000 ETF (IWM), with a US$32bn market cap, and Vanguard's Small Cap ETF (VB), with a US$20bn size. The largest small cap growth ETF is Vanguard's VBK, with a US$8bn size, and the largest value focused small-cap ETF (VBR) with a US$10bn size.
Risks: Deeper recession and FAANGM dominance
We highlight two particular risks to our positive US small-cap view from a longer and deeper recession and from a continuance of FAANGM dominance.
- The recession could deepen and high-yield spreads stay high for an extended period. The US is already facing one of the largest GDP falls of any country globally, and this has driven an unprecedented policy response. A unsuccessful gradual reopening of the US economy or a second wave of infections could lengthen and deepen the recession and keep high-yield bond spreads above average levels. All this would impact the small-cap relative performance.
- Continued FAANGM dominance. A significant portion of the large-cap outperformance in recent years has been driven by the FAANGM stocks - the six largest tech related US stocks. These now represent 20% of the S&P 500, double the weighting of only five years ago. We expect these stocks to come out of the crisis stronger than going in. This could continue to "crowd out" small-cap performance.
Conclusion: Small cap one of our favorite cyclical recovery plays
The US small-cap price performance has lagged versus large caps, both in the market crash and in the prior year. Market concerns have been focused on high leverage, cyclical index composition, and domestic focus. We now believe small caps are attractive. The valuation premium is at a decade low, earnings revisions and outlook are no worse than for large cap, whilst the Fed is intervening in the high-yield credit market. The attractive IT and Healthcare are the two largest small-cap sectors, and small cap has traditionally led in the market recovery. Small cap, real estate, and Europe are our select cyclical recovery allocations with the best risk/reward.
This article was written by
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