Small cap stocks: overshadowed opportunity amid mega-cap momentum

U.S. small cap stocks, typically defined as those with a market capitalization of less than $2 billion, have historically offered higher returns than large cap stocks over the long term.¹ This phenomenon, known as the small cap premia, is based on the idea that smaller companies are riskier, less efficient, and more prone to failure than larger ones, and therefore require a higher expected return to attract investor capital. However, in recent years, this small cap premium has seemingly vanished, as large cap stocks have outperformed by wide margins. In this article, we explore some of the rationales for this recent trend, and why we believe that small cap stocks may be due for a reversal.

Small cap index composition

One factor that has contributed to the recent disappearance of a small cap premia is the changing composition of major cap-weighted stock market indices. The S&P 500 Index, a capitalization-weighted index, has become increasingly dominated by a handful of mega-cap technology companies, that have grown rapidly and consistently over the past decade.

But if we excluded the top names from each index annually, not necessarily the “Magnificent 7” stocks alone, but the largest seven stocks every year of the last five years, we could explain most of the excess return of the S&P 500 over the Russell 2000. Absent these largest names, the S&P 500 delivered 11% vs. 10% annually for the Russell 2000 over the last five years. Still a large cap outperformance, but much smaller premium than industry headlines would suggest.

If we look at the index composition from a sector perspective (in figure 1), technology represents 15% more in the large cap index than small cap index. Bear in mind, this is after sectors were significantly reconstituted to take constituents traditionally categorized as technology and rebalance them toward sectors such as industrials, energy and real estate firms.

As a result of some of this more cyclical sector exposure, the Russell 2000 has lagged the S&P 500, especially during periods of market volatility and increased uncertainty. Figure 2 shows the cumulative return of the S&P 500 and the Russell 2000 since 2014. While the S&P 500 has outperformed the Russell 2000 by a significant margin over this period, the market environment has been one characterized by persistent macro uncertainty. Investors need to evaluate whether this macro backdrop will persist going forward.

Evolving market dynamics

Markets have evolved dramatically over the last 10 years, and the benefits of size and scale have been significant. Large companies benefited from strong competitive advantages that have propelled their performance. Innovation, advancement of and investment in technology has created new opportunities, as well as challenges for businesses of all sizes, but especially for smaller companies.

On one hand, technology has enabled small cap companies to innovate, compete, and reach new markets and customers. On the other hand, technology has also increased the competitive pressure and disruption from large cap companies. Big investments in areas like cloud computing infrastructure, AI training and electric vehicle manufacturing may have made it difficult for small firms to keep pace with their larger peers. These dynamics may help explain why larger companies have delivered bigger gains.

Private markets and a dearth of initial public offerings (“IPOs”) is another evolving dynamic that have challenged public small cap returns. Private companies have tended to stay private longer, and these markets are deeper than ever before. The best in class, highest growth companies have stayed private for longer and generally have “leap frogged” the entrance into the public small cap universe. In figure 3, we can see how historical startups like Apple or Amazon IPO’d as small caps, only three or four years after their founding. Some of these company’s strongest growth (and return to investors) were during that maturation from small to large companies. Today, the next cohort of technology companies like SpaceX or Stripe are staying private well into the business’ teenage years, and rival the size of many publicly traded large cap peers.

The recent trend has been for private companies to remain private for longer, bypassing small-cap IPOs and directly entering the large-cap universe. This shift has affected the historical premium associated with small-cap stocks, which has been notably absent during the recent market cycle.

Macroeconomics

A third factor that may have contributed to the dormancy of the small cap premia over the last 10 years is a shift in the macroeconomic environment that has favored large-cap stocks over small-cap stocks. A prolonged period of low interest rates after the global financial crisis has enabled large cap companies to borrow cheaply and invest in growth opportunities, such as mergers and acquisitions, research and development, and capital expenditures.

Small-cap companies, on the other hand, typically have less access to credit and are more sensitive to changes in interest rates. Approximately 1/3 of the Russell 2000 are financed with floating rates, compared to only 6% of companies in the S&P 500². This combination leads to small caps generally having higher debt and lower credit ratings than their large cap counterparts. As a result, a larger portion of small cap companies are financed by bank loans, typically floating rate, compared to large caps that generally have bond financing with fixed maturities. As rates have increased, that financing structure has presented a greater challenge to the small cap space.

The resilience and potential of small cap stocks

While the small-cap premia may have temporarily dimmed, the breadth and depth of the small-cap universe remains as alluring for active investors as ever. Recent market dynamics, including shifts in index composition and macroeconomic factors, have fueled large-cap outperformance, but we believe longer term macroeconomic dynamics are likely to benefit small caps.

Part of the changing market dynamics has also led to an evolution of small cap exposures as “SMID” has become a more frequently chosen exposure to complement large caps in portfolios. For example, by moving from the Russell 2000 Index to the Russell 2500 Index, the market cap and liquidity double with only the addition of 500 names. Moreover, the relative stability of the benchmark presents an interesting alpha opportunity as names move across market caps.

Apart from evolving small cap exposure, one potential catalyst for reigniting small-cap outperformance lies in the Federal Reserve’s eventual interest rate cuts. Should rates indeed decline, smaller companies stand to benefit disproportionately.

Moreover, if markets continue their upward trajectory, the small-cap sector could showcase its dynamism. Small-cap companies are more sensitive to economic cycles, and history shows us that small caps tend to benefit most from expansionary cycles. Current valuations for these firms, coupled with an environment of improving earnings-per-share growth could lead to a wider range of these companies delivering competitive returns. These favorable characteristics, coupled with U.S. economic gains from reshoring, the CHIPS Act, and ongoing infrastructure investment, are poised to accelerate earnings for these smaller firms.

While the small-cap premia may have taken a temporary breather, we believe the stage is set for their resurgence. As Systematic investors, we recognize the inherent opportunities within the universe and are confident investors who are willing to take the risk and invest in the small cap universe will reap the long-term rewards of this dynamic market segment.