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Is there still a case for small caps? Head of Multi-Asset Strategy Adam Berger and Peter Carpi, a small- and micro-cap manager, consider the evidence and the asset allocation implications.
Adam: Many asset allocators I speak to still see the long-term case for small caps, but struggle with the recent stretch of market underperformance. How would you put it in perspective?
Peter: There’s no question that we’ve been through a challenging period in relative terms. The Russell 2000 Index of small-cap stocks achieved an annualized return of about 7% over the past 10 years, which hasn’t stacked up well against large caps, with the S&P 500 up 13% on an annualized basis over the same period. For allocators asking whether they should still care about small caps, I think it’s useful to look at history. In a recent article, my colleagues analyzed nearly 100 years of data and found that there’s been a change in leadership between large caps and small caps about every dozen years or so (Figure 1). And that’s about the length of the current large-cap leadership cycle, which suggests that a switch to small-cap leadership may be due if the historical pattern holds.
We’ve also seen that past periods of large-company leadership are often driven by innovation, not unlike what we’ve seen recently with the “Magnificent Seven” and AI. In the 1890s, it was all about steel, oil, railroads, and banking, and investors just needed to own Federal Steel, US Steel, and anything with “Pacific” in the name. Fast forward to the Roaring ’20s, when telephones, electricity, and automobiles were the innovations of the moment and investors did well to hold stocks like Ford, Westinghouse, and American Telegraph & Telephone. Next came the post-World War II era and the dawn of commercial aviation and chemicals and plastics. In the late 1960s and 1970s, we saw the era of the “Nifty Fifty” stocks — the equivalent of today’s Magnificent Seven. Sears Roebuck was the “Amazon” of the day, revolutionizing the way consumers shopped. Kodak and Polaroid were the “Apple” analogue. There are other examples, including the dot-com era, but the point is that in each of these previous cycles, the innovation and technology spread beyond a small group of large companies and out to the broader economy fairly rapidly, so that smaller companies reaped the benefits as well.
With that history in mind, I think investors should be watching for signs of technology diffusion beyond the Magnificent Seven.
Adam: How will you be looking for signs of that technology diffusion within small caps?
Peter: Fortunately, there are better tools to help with that today than during previous innovation cycles. For example, job market data can be used to track the movement of talent to and from the larger companies currently benefiting from AI. It’s not about those at the level of, say, Sam Altman, but those one or two levels below him — these are often the key innovators at the big companies who have filed patents or written papers in their fields. Early in the innovation cycle, they want to go to the “Nvidias” of the world. But then you end up with hundreds of great minds in one place, and eventually they each want to pursue their own ideas. If you track their mobility, you often see them end up at VC-backed start-ups, which can eventually become attractive public small-cap companies, as well as at existing small-cap companies where innovators have more say in the strategic direction of the firm than at the larger companies.
Adam: It’s not all about technology of course — small caps are a large and diverse opportunity set. From an alpha standpoint, what do you find typically differentiates the winners from the losers?
Peter: For me, it’s crucial to search for positive fundamental inflection points in a company’s business. Given the breadth of the small-cap market, which you noted, there are many potential drivers of such an inflection. They might include a change in a company’s strategic direction brought on by a leadership change; an increase in pricing power like those we saw during the pandemic, created by supply chain disruptions; or the launch of a new product or addition of capacity resulting from investments in the physical plant or the sales force. The key is identifying these shifts before the market does and, in my experience, using tools like data science makes a difference.
Adam: How might data science help you get ahead of the market?
Peter: Finding inflection points early requires being on top of what companies are doing and saying in almost real time. Given the number of companies, this “needle in the haystack” exercise can be challenging even for a fully staffed team of analysts. That’s where tools like our proprietary natural language processing techniques can come in. Let’s say, for example, that a company’s management team mentions adding capacity or launching a new product in a quarterly call. The question for investors is whether the management team is always talking about adding capacity and launching new products, or whether this really is something new and, therefore, a potential inflection point. With the right tools, it’s possible to rapidly search previous management comments and determine whether the latest comments truly stand out.
Adam: I’m often asked about two issues when it comes to the small-cap market: the use of leverage by some companies and the number of unprofitable companies. How do you view these issues?
Peter: Those questions come up frequently in my client discussions as well. On the subject of leverage, my first response is that it’s company specific — there is an appropriate level of leverage for every company, and for some, that level is zero. It’s also somewhat industry specific. I’m more comfortable with leverage in the financial sector, for example, where it’s part of the business model. And I’m a little more comfortable with it in, say, the industrial sector, where the businesses tend to be more sustainable, than in areas like consumer or health care, where a business might face greater obsolescence risk. Finally, I’d add that I don’t think the small-cap market overall is highly levered right now. Capital was cheap over the past decade, and it was easy for companies to improve their balance sheets and term out debt.
In terms of profitability, it is true that small-cap companies, broadly speaking, are at a low point historically speaking. But I think this has more to do with the makeup of the small-cap market than any inherent profitability problem with small-cap companies. For example, in the 1990s, a large number of regional banks entered the US small-cap market, and, in general, they were very profitable companies. On the other hand, they weren’t companies that drove innovation in their industry — I doubt many of them filed any new patents.
Fast forward a couple of decades and we saw a shift in the small-cap market, with a wave of biotech IPOs. It’s abated in the last two years, but at last count, there were about 250 biotech stocks in the Russell 2000 Index. That means more innovation. Small-cap biotechs are largely clinical-stage companies, and that’s a business model that means losing money until drugs are approved and sales ramp up. But importantly, the balance sheets of these companies tend to be strong with healthy cash levels and little to no debt. So yes, the small-cap space has lower profitability right now, but also a lot more innovation than it did 25 years ago — and to my earlier point on technology diffusion, I expect there’s more to come.
Adam: We polled 250 asset owners in March and found that more than two-thirds were planning to spend time focusing on small-cap stocks this year. With that in mind, I’ll close by sharing a few of my own thoughts on small-cap allocations.
I expect mean reversion in small caps
In the very long run, small caps have outperformed large caps (as reflected in the overall slope of Figure 1), though the evidence of a small-cap premium has been less obvious over the last 40 years. But given the cyclicality that Peter discussed, it’s not clear that matters. I think the stage may be set for mean reversion in small-cap performance. That conclusion is consistent with the capital market assumptions of our Investment Strategy & Solutions Group (iStrat), which have US small-cap stocks beating US large-cap stocks by 2% a year over the next 10 years. The big risk to this view is that we continue to have a degree of “oligopolization,” and the technology diffusion Peter described doesn’t come to fruition.
But there’s a broader case for a small-cap allocation too
The cyclical argument notwithstanding, timing mean reversion can be challenging and may not be necessary with small caps. I believe there’s a pure diversification argument for having exposure to the broad small-cap opportunity set, especially for allocators who have a significant large-cap overweight currently. And even if there’s not an expectation that small-cap beta will outperform, the alpha potential of this less efficient segment of the market may justify an allocation.
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