The case for a strong US small-cap run

We believe that current economic and investment conditions are creating potential advantages for active small-cap managers, with a particular edge developing for higher-quality small-cap companies.

The normalization of rates is already leading companies to make what we see as more rational capital allocation decisions—because balance sheets and financial leverage matter again. This is especially true in small-cap, with its high percentage of loss-making companies, and where debt tends to be more variable than fixed. In this context, a more historically typical interest rate era should reward successful operational performance—as opposed to financially engineered profits—and thus supports the potential for higher-quality businesses to outperform. We define high-quality businesses as those with low debt, the ability to generate free cash flow, high returns on invested capital, and management teams with proven skill at allocating capital prudently and effectively.

Within the Rusell 2000 Index—where the majority of passive small-cap index investments focus—43% of the constituents are loss-making companies, with many also having a relatively high degree of financial leverage. From a quality standpoint, actively managed small-cap portfolios look better positioned for success than the overall benchmark because active managers tend to prefer companies with attributes such as high—and consistent—returns on invested capital, low debt, free cash flow generation, and steady profitability.

All these developments may be setting the stage for above-average small-cap performance. As of 2/29/24, the Russell 2000 was down -13.0% from its last peak on 11/8/21. With rates stabilizing and the US economy growing, the potential for mean reversion potential appears very high. Moreover, the 3-year average annual total return for the Russell 2000 as of 2/29/24 was 0.9%. Why is this dismal return notable? In 66 of 67 periods—or 99% of the time—when the index’s 3-year average annual total return was 3% or lower, subsequent 3-year annualized returns were positive and averaged 16.7%—a significantly higher mark than the Russell 2000’s 10.7% monthly rolling 3-year average annual return since inception (12/31/78).

Small-caps had a peak to trough decline of more than 30% in the current cycle and in many cases have already discounted a recession that has yet to materialize. We are therefore expecting a sustained catch-up phase for small-caps as returns have fallen significantly below average on a 1-, 3-, 5-, and 10-year basis through the end of February.

Given these recent returns for the Russell 2000, it will probably come as no surprise that small-cap stocks remain undervalued on both an absolute basis and relative to large-cap stocks. What is less obvious is that select small-cap businesses continue to flash considerable earnings potential. As of 12/31/23, the weighted harmonic price-to-earnings ratio (“p/e ratio”) for the Russell 2000 was well below its historical average (14.9x versus 17.9x) while large cap traded at the substantially higher P/E of 23.3x at the end of 2023.

In a similar vein, we have written recently that relative valuations for small-caps relative to large-caps were near their lowest in 25 years as of 12/31/23 based on our preferred index valuation metric, enterprise value to earnings before interest and taxes, or EV/EBIT. Further, earnings growth for small-caps is expected to be double that of large caps in 2024—which is consistent with the mostly positive news that our portfolio management teams heard during February 2024’s earnings season.

Finally, we see a secular opportunity for active small-cap management. Small-caps have greater exposure to US economic activity. Many smaller companies will likely see powerful secular benefits from nascent trends in AI, reshoring, supply chain shifts, and deglobalization. The CHIPS Act and several infrastructure projects will also boost US-centric manufacturing activity, benefiting smaller companies. All these activities will take place against the favorable backdrop of falling inflation, narrowing credit spreads, and the high probability that the Federal Reserve will cut rates later in 2024. To be sure, we think the potential is high for a sustained period of strong small-cap performance on both an absolute and relative basis.