Market & Topical Perspectives

Separating the Wheat from the Chaff

Separating the Wheat from the Chaff

After a productive start to 2023, US small cap stocks withered among the turmoil that struck the country’s regional banks in the spring.

Key Takeaways

  • Though roiled by the discord surrounding regional banks earlier in 2023, small cap stocks rallied sharply in November and December to deliver a strong annual return.

  • The prospect of easier monetary conditions and a turning point in the business cycle could serve as a tailwind for small cap shares in 2024, but we believe that trying to anticipate policy changes is a poor foundation for investment success.

  • Valuations for small cap shares are below their own historical averages and relative to their large cap counterparts. While some reversion to long-term means could help small stocks, in our view, passive index exposure is unlikely to be a path to optimal returns in what is a particularly inefficient market.

  • We believe investors ultimately may be rewarded for buying good companies at low prices, a strategy that historically has provided opportunities for active investors to outperform indexes.1

While small caps missed out on a powerful midyear rally concentrated in a handful of very large tech-related names, market performance broadened into year-end on hopes of a dovish pivot by the Federal Reserve. This change in sentiment more than offset what had been year-to-date losses for the small cap universe while also highlighting the volatility so common in the space.

Easier monetary conditions are widely anticipated for 2024 and could provide tailwinds for smaller stocks. So, too, could a reversion toward long-term relative valuation means for a market segment trading at a significant discount to both its own historical valuation and that of large caps. Of course, these developments are by no means guaranteed; in fact, only a few weeks into the new year, markets have already begun to temper their 2024 rate-cut expectations.

We recognize that top-down forecasting is beyond our scope and instead focus on identifying quality companies with catalysts for improvement trading at what we view to be a discount to normalized valuation. The volatility in the small cap market throughout 2023 provided us with ample opportunities to acquire such companies, potentially sowing the seeds for a bountiful harvest ahead.

Tight Money Weighed on Small Caps in 2023 as a Subset of Large Companies Thrived

Following a dismal 2022, US equities staged a strong rebound in 2023 as markets began to anticipate the end of the Federal Reserve’s rate-hike cycle and a potential policy pivot. Headline returns belie what proved to be a more nuanced period, however. Though the S&P 500 Index climbed 26.9% in 2023, a large portion of this gain was driven by a small group of very large stocks whose exposures to alternative intelligence technologies captured investor attention; by year end, the “Magnificent Seven” of Alphabet, Amazon, Apple, Meta, Microsoft, Nvidia and Tesla comprised 28% of the index.2,3In contrast, the S&P 500 Equal Weight Index, which allocates identical weightings to each company in the S&P 500, returned a relatively meager 13.8% in 2023, lagging the 16.9% gain posted by the Russell 2000 Index.4

Small caps historically have done well in rising-rate environments, but their early-2023 performance—after a very strong start—was derailed by the turmoil that struck regional banks in March. Not only did the collapse of Silicon Valley Bank, First Republic Bank and Signature Bank send shares of small cap banks broadly lower in fear of systemwide contagion, it reinforced the already tighter lending standards of the banks that many small companies depend on for financing. Meanwhile, the tight-money environment also dampened mergers and acquisitions (M&A) activity by private equity vehicles, historically a source of support for small cap valuations. Despite these headwinds, the Russell 2000 ultimately delivered robust gains for the year, staging a spirited rebound in November and December as market sentiment appeared to coalesce around a “soft landing” scenario for the economy.5

Stabilizing Interest Rates May Finally Refocus Investor Attention on Fundamentals

Last year’s volatility provided opportunities to acquire fundamentally solid companies at valuations we believe were distorted by cyclical forces. There are reasons to think that these actions may be rewarded in 2024, especially if slowing economic activity and cooling inflation prompt the Fed to cut its policy rate, as bond futures markets expect.6 Easier monetary conditions may bolster investor risk appetites, provide small companies with greater operational and financial flexibility, and jumpstart M&A activity among private equity funds eager to deploy their massive stores of dry powder.

Though by no means foolproof, troughs in the Conference Board’s Leading Economic Index (LEI)—a composite index of economic and market variables that in aggregate purports to anticipate potential turning points in the business cycle—historically have augured well for the performance of small cap stocks relative to large caps, as illustrated in Exhibit 1. Recent LEI data suggest the metric may be bottoming after a long period of decline, at least partly due to indications of cooling inflation. At 2.6% and 2.9%, respectively, growth in headline and core personal consumption expenditures (PCE) price indexes ended 2023 at early-2021 levels.7 Mixed employment data has clouded the forecast, however. While a number of metrics have reflected the impacts of tighter monetary policy, nonfarm payrolls have persistently defied expectations,8 and wage growth remains at a level not seen since the early 2000s.9 These disparate data points keep “higher for longer” rates firmly in play—and serve as good reminders of why we focus on the factors we can control rather than trying to make timing calls.

 

Exhibit 1. Troughs in the Leading Economic Index Historically Have Presaged Small Cap Outperformance
US Leading Economic Index, January 1960 through November 2023

Small Cap Exhibit 3

Source: The Conference Board, FactSet, Bloomberg; data as of December 31, 2023.

Seeking Prospects for Revaluation

In the final analysis, investors can control only which stocks they buy and how much they pay for them. We believe those who devote their efforts to identifying and investing in good businesses at attractive valuations may see the most success over the long run, and current small cap valuations continue to suggest an environment ripe for finding such companies despite strong gains in 2023.

As illustrated in Exhibit 2, the Russell 2000 appears very cheap on a trailing price-to-earnings basis, relative both to its historical average (a 17% discount) and to the S&P 500 (a 39% discount).11 Notably, the last time small cap valuations hit similar lows was in 2009 amid the global financial crisis, after which the Russell 2000 delivered returns of 30% for each of the next three years.12 Further, it’s worth remembering that a discount for small cap stocks is a relatively recent phenomenon. For most of the period between 2003 and 2017, small caps traded at a premium to large caps, and small cap stocks—small cap value stocks, in particular— have outperformed their large cap value and growth counterparts over full investment cycles.13 Mean reversion historically has had a powerful influence over financial markets and may serve as an additional tailwind for small stocks.

Exhibit 2. Small Caps Appear Cheap Compared to Large Caps and to Their Own History
Trailing Price-to-Earnings Multiples, January 2004 through January 2024

Small Cap Exhibit 4

Source: FactSet; data as of January 31, 2024.

As favorable as small cap valuations may be at the index level, buying the index is not likely a path to optimal returns, in our view. As Warren Buffet, quoting Benjamin Graham, observed, a “wildly fluctuating market means that irrationally low prices will periodically be attached to solid businesses.”13 Small caps represent one such wildly fluctuating market, and its pronounced volatility and inefficiency historically have created opportunities for skilled active managers to generate alpha—more so than any other equity asset class, as shown in Exhibit 3.

Exhibit 3. Small Cap Markets Have Historically Offered Alpha-Generating Opportunities
Active Manager Success Rate versus US Indexes by Morningstar Category; Periods Ended January 31, 2024

Small Cap Exhibit 6

Source: Morningstar; data as of January 31, 2024.

Amid what we believed to be an abundance of attractive investment opportunities in 2023, we remained focused on targeting really good companies while controlling the one variable that we can—the price we pay. Given that 42% of the companies in the Russell 2000 were unprofitable as of September 30, 2023—versus only 7% of the S&P 500—we think sorting the wheat from the chaff is a worthwhile endeavor in the broad and diverse small cap universe.14 Regardless of the central bank’s actions in 2024, it seems likely companies that are cheap for a reason will continue to face a challenging operating environment, while many of those with solid businesses and catalysts for improvement may progress toward valuations more consistent with historical levels.

 

1. Source: Morningstar; data as of January 31, 2024.
2. Source: FactSet; data as of December 31, 2023.
3. The term “Magnificent Seven” is widely used in the financial media and elsewhere to refer to these seven US technology-related stocks
that drove an outsized share of equity market gains in 2023.
4. Source: FactSet; data as of December 31, 2023.
5. Source: FactSet; data as of December 31, 2023.
6. Source: Bloomberg; data as of December 12, 2023.
7. Source: Reuters, Bureau of Economic Analysis; data as of January 26, 2024.
8. Source: Bureau of Labor Statistics; data as of February 2, 2024.
9. Source: Current Population Survey, Bureau of Labor Statistics, Bureau of Economic Analysis, Federal Reserve Bank of Atlanta; data as of January 10, 2024.
10. Source: FactSet; data as of January 31, 2024.
11. Source: FactSet; data as of January 31, 2024.
12. Source: FactSet and Kenneth R. French data library; data as of August 31, 2023.
13. Warren Buffet, Chairman’s Letter to the Shareholders of Berkshire Hathaway Inc. (March 4, 1994).
14. Source: FactSet, data as of December 31, 2023.
 

The opinions expressed are not necessarily those of the firm. These materials are provided for informational purposes only. These opinions are not intended to be a forecast of future events, a guarantee of future results, or investment advice. Any statistics contained herein have been obtained from sources believed to be reliable, but the accuracy of this information cannot be guaranteed. The views expressed herein may change at any time subsequent to the date of issue hereof. The information provided is not to be construed as a recommendation to buy, hold or sell or the solicitation or an offer to buy or sell any fund or security.

Past performance is not indicative of future results.

Risk Disclosures

All investments involve the risk of loss of principal.

The value and liquidity of portfolio holdings may fluctuate in response to events specific to the companies or markets, as well as economic, political or social events in the US or abroad. During periods of market volatility, the value of individual securities and other investments at times may decline significantly and rapidly. The securities of small and micro-size companies can be more volatile in price than those of larger companies and may be more difficult or expensive to trade.

Diversification does not guarantee investment returns and does not eliminate the risk of loss.

Alpha is a measure of risk-adjusted performance. Alpha measures the amount that the investment has returned in comparison to the market index or other broad benchmark that it is compared against.

The Conference Board Leading Economic Index (LEI) is a composite index of economic and market variables that aims to identify potential turning points in the business cycle.

Dry powder refers to committed capital that has yet to be invested.

Personal consumption expenditures (PCE) price index is a measure of consumer spending on goods and services among households in the US. Indexes are unmanaged and one cannot invest directly in an index.

Indexes are unmanaged and one cannot invest directly in an index.

Russell 2000® Index (Gross/Total) measures the performance of the small-cap segment of the US equity universe. It includes approximately 2,000 of the smallest securities based on a combination of their market cap and current index membership. A total-return index tracks price changes and reinvestment of distribution income.

S&P 500 Index (Gross/Total) is a widely recognized unmanaged index including a representative sample of 500 leading companies in leading sectors of the US economy. Although the S&P 500 Index focuses on the large-cap segment of the market, with approximately 80% coverage of US equities, it is also considered a proxy for the total market. The S&P 500 includes dividends reinvested. A total return index tracks price changes and reinvestment of distribution income.

Large Blend Morningstar Category: Large blend portfolios are fairly representative of the overall US stock market in size, growth rates and price. Stocks in the top 70% of the capitalization of the US equity market are defined as large cap. The blend style is assigned to portfolios where neither growth nor value characteristics predominate. These portfolios tend to invest across the spectrum of US industries and, owing to their broad exposure, the portfolios’ returns are often similar to those of the S&P 500 Index.

Large Growth Morningstar Category: Large growth portfolios invest primarily in big US companies that are projected to grow faster than other large cap stocks. Stocks in the top 70% of the capitalization of the US equity market are defined as large cap. Growth is defined based on fast growth (high growth rates for earnings, sales, book value and cash flow) and high valuations (high price ratios and low dividend yields). Most of these portfolios focus on companies in rapidly expanding industries.

Large Value Morningstar Category: Large value portfolios invest primarily in big US companies that are less expensive or growing more slowly than other large cap stocks. Stocks in the top 70% of the capitalization of the US equity market are defined as large cap. Value is defined based on low valuations (low price ratios and high dividend yields) and slow growth (low growth rates for earnings, sales, book value and cash flow).

Small Blend Morningstar Category: Small blend portfolios favor US firms at the smaller end of the market-capitalization range. Some aim to own an array of value and growth stocks, while others employ a discipline that leads to holdings with valuations and growth rates close to the small cap averages. Stocks in the bottom 10% of the capitalization of the US equity market are defined as small cap. The blend style is assigned to portfolios where neither growth nor value characteristics predominate.

Small Growth Morningstar Category: Small growth portfolios focus on faster-growing companies whose shares are at the lower end of the market-capitalization range. These portfolios tend to favor companies in up-and-coming industries or young firms in their early-growth stages. Because these businesses are fast-growing and often richly valued, their stocks tend to be volatile. Stocks in the bottom 10% of the capitalization of the US equity market are defined as small cap. Growth is defined based on fast growth (high growth rates for earnings, sales, book value and cash flow) and high valuations (high price ratios and low dividend yields).

Small Value Morningstar Category: Small value portfolios invest in small US companies with valuations and growth rates below other small-cap peers. Stocks in the bottom 10% of the capitalization of the US equity market are defined as small cap. Value is defined based on low valuations (low price ratios and high dividend yields) and slow growth (low growth rates for earnings, sales, book value and cash flow).

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