Small Caps: Ripe for Further Outperformance?

Despite their reputation small caps do not outperform in every market environment, but are the current conditions ripe for outperformance?

Gordon Rose, CIIA, CAIA, 4 October, 2011 | 5:22PM
Facebook Twitter LinkedIn

Small cap equities are well known for their higher returns and higher volatility as compared to large caps and are often used to complement large- and mid-cap exposure in a well diversified equity portfolio.

However, small caps do not outperform in every market environment. In fact, during bear markets, small caps can experience greater losses than large caps. In Europe, the EURO STOXX 50 Index lost 42.40% of its value in 2008, whereas the EURO STOXX Small Index fell 46.40%. However, this relationship did not hold in recent bear markets in the U.S. The RUSSELL 2000 Index outperformed the S&P 500 Index not only during the last bear market in 2008 (-33.79% vs. -37.00%) but also during 2000-2001 timeframe.

This article will take a closer look at small caps and try to identify market environments where they are most likely to outperform large caps. Common sense would argue that small caps always outperform during bull markets and underperform during bear markets. But let’s have a closer look to see if that is necessarily true.

What Are Small Caps?
Generally, small caps are defined as those having a market capitalisation of between $300 million and $2 billion. They are often considered to have greater growth potential compared to more mature large cap firms.

Also, more often than not the sector weightings of small cap indices deviate from large cap indices; hence the different size indices are often influenced by different macroeconomic factors. The Russell 2000 Index, for instance, is more exposed to financial stocks and less exposed to energy stocks as compared to the S&P 500 Index. Hypothetically, a strengthening financial sector and declining energy prices would benefit the performance of the Russell 2000 Index relative to the S&P 500 Index. However, the small-cap index also favours regional banks that are reliant on mortgage lending. As the US housing market remains fragile, this could add downward pressure on the index. The EURO STOXX Small Index is biased towards consumer goods and services and industrials sectors. Weak consumer demand in Europe and soft demand for industrial products (e.g. due to a slow down in Emerging Markets) could therefore weigh on the performance of the EURO STOXX Small Index relative to the EURO STOXX 50 Index.

Small Caps Outperformance
Small caps have outperformed large caps by a large margin since markets reached their nadir in March 2009. The EURO STOXX Small Index has outperformed the EURO STOXX 50 Index by almost 12 percentage points on an annualised basis since that time. Over the same time period, the RUSSELL 2000 Index returned a 9.5 percentage point premium over the S&P 500 Index on an annualised basis.

But why have small caps outperformed? Is this just a coincidence or is small cap outperformance more predictable? Let’s have a look.

When Do Small Caps Tend to Outperform?
Expansionary monetary and fiscal policies have created a supportive environment for small cap equities. Periods of negative real interest rates are usually the product of a broader crisis, during which large-cap companies will seek to cut costs and preserve cash, leaving them with huge cash reserves. During the following quarters, many of these same companies unload their cash by acquiring small caps, hence explaining a portion of the outperformance of small caps in such circumstances. Non-financial U.S. Corporations are currently believed to sit on around $1.24 trillion in cash whereas the cash pile of the STOXX Europe 600 Index companies is estimated to be $690 billion.

The graphs below show real interest rates (3 month Treasury Bill yield minus CPI) versus the 3 month performance ratio of small cap equities versus large caps—when the green line is above zero it indicates small cap outperformance. As we can see, there is a tendency for small caps to outperform large caps during periods of negative real short-term interest rates, i.e. low nominal interest rates coupled with high inflation.

Looking at the cumulative outperformance (click here), we can see that small caps have outperformed large caps in the U.S. over the last 20 years, whereas small caps in Europe have underperformed large caps.

But why is that? The answer most likely lies in the differences in interest rate environments. The U.S. experienced several periods of negative real interest rates over the last 20 years as the graph above indicates. In contrast, real interest rates remained in positive territory in Europe for most of this period. As negative real interest rates environments are beneficial for small caps, this could help to explain the better performance of small caps relative to large caps in the U.S. Another noticeable difference between the two sides of the Atlantic is the relative weighting of the financial sector within their respective small cap benchmarks. The Russell 2000 Index is overweight financials whereas the European small cap indices underweight this sector with respect to their large cap benchmarks. As the Russell 2000 Index favours regional banks that are reliant on mortgage lending, the index probably benefited from the housing market boom in the US.

The current period of outperformance of small caps is the longest in history; the Russell 2000’s cumulative return since April 1999 is 135.2% (through 31/07/2011). This compares to a total return of 25.3% for the S&P 500 Index over the same period. In Europe, the outperformance did not start until January 2000. The EURO STOXX Small index’s cumulative return reached 70.6%, compared to the EURO STOXX 50 Index which lost 27% of its value over that time period. However, these superior returns were not so much driven by small caps themselves but rather the collapse of large cap P/E multiples. Since 2000, the P/E ratio for the S&P 500 Index dropped from 25.1 to 14.6. In contrast, the P/E multiple for the Russell 2000 has increased from around 14.2 to 16.8 during the same time period. Large cap stocks were massively overvalued in 2000 as long term earnings growth expectations were far higher for large caps than for small caps. During the “TMT” bubble, lofty large cap valuations were concentrated in three sectors: technology, media, and telecommunications. Valuations in the remaining sectors remained fairly reasonable. At one time, the largest 30 companies in the S&P 500 had a combined P/E multiple of 46 compared to a P/E of 23 for the remainder of the S&P 500 Index’s constituents. As a result, the weighted average P/E of the S&P 500 reached 30 in 1999.

Going Forward
Given negative real interest rates in the U.S. and the recent commitment from Fed Chairman Ben Bernanke to keep interest rates at the current low levels for at least another two years, the favourable interest rate environment for small caps should remain in tact. Even though the ECB hiked interest rates twice already this year, the bank recently reactivated its bond purchasing program and could thereby further stoke inflation. This will likely keep the European monetary union in negative real interest rate territory as well. Nevertheless, the latest “crash” in stock markets around the world was driven by fear over the prospects of global growth and not necessarily by the downgrade of the U.S. by S&P, given the subsequent rally of Treasuries. Therefore, global stock markets look to be in for a rather bumpy ride in the near future, including small caps.

As always, investors should make sure they understand the macroeconomic drivers behind their desired investment. In addition, investors are advised to look at the index constituents to determine whether the investment is strictly in small caps or rather blends in mid caps as well.

In addition, investors interested in how small caps could benefit their portfolio are advised to read the article Could Your Portfolio Benefit From Small-Caps?

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

Facebook Twitter LinkedIn

About Author

Gordon Rose, CIIA, CAIA,

Gordon Rose, CIIA, CAIA,  is an ETF analyst with Morningstar Europe.

© Copyright 2024 Morningstar, Inc. All rights reserved.

Terms of Use        Privacy Policy        Modern Slavery Statement        Cookie Settings        Disclosures