It would be almost impossible for investors not to be aware of the strength of large cap stocks over recent years.
Any exposure to the ‘Magnificent 7’ or the GRANOLAs, their European equivalents, has driven investor returns and some of these stocks have now reached almost unprecedented capitalisations as a result.
By contrast, firms further down the market capitalisation spectrum across the US, UK and Europe have been largely overlooked by investors, small caps stocks in particular.
This means that many now trade at exceptionally low valuations relative both to their larger peers and historic averages.
Given this wide spread in valuations alongside a shift in the economic backdrop, investors could well ask whether the time has come to allocate more capital to small caps.
Much of the attraction of large caps stems from the fact that they typically hold dominant positions within their respective sectors, acting as an effective barrier to competition, and their earnings profiles tend to be consistent and stable.
For instance, the constituents of the Magnificent 7 – Apple, Microsoft, Amazon, Alphabet, Meta, Nvidia and Tesla – have soared as a result of their robust earnings, the strength of the trend towards AI and their market leadership in technology and innovation, key buzz words of late.
They have been responsible for most of the returns of the S&P 500 over the last couple of years, and despite concerns over concentration, there has been little impact on investors’ voracious appetite for them.
Additionally, these stocks have been beneficiaries of the volatility that has characterised markets since the pandemic.
Investors reacted to the unsettling economic backdrop of high inflation, high interest rates and the threat of a global recession by favouring large cap stocks which are seen as less sensitive to fluctuations in sentiment.
Looking ahead, however, is the outlook for small cap stocks starting to look more favourable?
Meanwhile, small caps’ perceived weaker balance sheets, lack of pricing power and greater economic sensitivity dramatically reduced their appeal.
This has led to significant outflows from small cap funds, exacerbating their relative underperformance while the massive weightings of large-cap growth stocks in indices overshadowed the opportunities within the small-cap universe, reinforcing the cycle of underperformance.
Looking ahead, however, is the outlook for small cap stocks starting to look more favourable?
There are several key developments that would suggest that it is. Principal amongst these are the beginnings of a reversal of fiscal policy across most developed markets towards lowering interest rates.
This reduces companies’ borrowing costs, lowers barriers to investment, and supports their capacity to expand, bolstering investor confidence. The trend among central banks to cut interest rates reflects another important consideration – lower inflation.
A lower inflationary environment both eases pressure on profit margins and encourages consumer spending, both of which present a more supportive environment to a much wider range of businesses.
This backdrop of lower interest rates and lower inflation promises to create conditions in which smaller companies can flourish.
Small cap stocks may be due to make a resurgence, but not all firms will be long-term winners
Firms that have survived the challenges of recent years are typically stronger, more capable of capitalising on investment opportunities and have the potential of taking a greater share of a consolidated market, as their weaker competitors fall by the wayside.
And while in the UK, the impact of the increase in employers’ National Insurance contributions may force some businesses that are already under pressure to fold, those with the strongest franchises will be better placed to absorb any costs that they cannot pass on.
Small cap stocks may be due to make a resurgence, but not all firms will be long-term winners. Stock selection will therefore be vital, but identifying the wheat from the chaff takes experience. This area of the market is not as widely covered by analysts as large caps and therefore requires much deeper fundamental research.
Is there any hope left for small caps?
This provides the opportunity for skilled active managers to add significant value by exploiting market inefficiencies and identifying high-quality companies, trading at attractive valuations.
Regardless of the relative merits of small versus large cap stocks, it is important all the same not to become fixated with one area of the market when building a portfolio for the long-term.
Rather, the emphasis should be on quality – a blend of investments with a combination of strong fundamentals and robust prospects for future growth – no matter where they sit on the market cap scale.
Mark Harries is chief investment officer at Square Mile Investment Consulting & Research
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