In a recent twist of market events, small-cap stocks, after hitting two-decade lows against the S&P 500, staged a significant rally following the Federal Reserve’s unexpected dovish policy shift. However, despite short-term fluctuations, concerns about the long-term viability of small-cap investments persist, with skeptics pointing to deep economic changes that have left smaller firms less profitable, less attractive, and more indebted.
Since the beginning of 2022, the Russell 2000 has experienced a 12% decline, in stark contrast to the S&P 500 and Nasdaq 100, which have largely recovered from earlier losses. Analysts, such as those at Verdad Advisors, argue that an industry shift towards private markets has resulted in a dearth of high-quality younger companies, leaving listed small-cap companies struggling, with loss-makers gaining market access while profitable companies opt for exits.
Jeff Burton, co-founder of Furey Research Partners, emphasized the challenges facing small-cap equities, acknowledging the industry’s struggle to overcome issues that have led to investor apathy. Despite the potential for a resurgence driven by wide valuation discounts, Burton recognizes the underlying challenges, particularly evidence of impaired profitability that appears to be a lasting characteristic of the market.
Verdad’s analysis highlights a stark contrast in the balance sheets of large and small businesses. Over the past two decades, the largest U.S. companies have doubled their earnings relative to interest payments, providing resilience against rising interest rates. In contrast, small caps have not matched this feat, contributing to concerns about the long-term outlook for the asset class.
Thushka Maharaj, a multi-asset strategist at JPMorgan Asset Management, points to secular reasons for the challenges facing U.S. small-caps, citing the preference for profitable companies to stay private and the growth of revenue among large established companies due to concentration in innovative technology.
The concerns raised by industry experts extend beyond near-term monetary outlooks. The dominance of mega-cap companies, particularly in artificial intelligence, has concentrated gains, leading to theories that U.S. markets have undergone fundamental transformation in the age of technology and prolonged periods of cheap money. Scalable software and networks favor incumbents, and new innovators are opting to remain private for longer, buoyed by the private equity boom.
As mega-cap dominance becomes apparent, the small-cap premium, traditionally associated with higher returns for riskier stocks, has been reassessed by JPMorgan Asset’s multi-asset team, citing changes in sector mix and growth in private capital. This reevaluation has led to reduced forecasts for small-cap returns, as the sector’s youthful potential has converged with larger companies in terms of sales growth.
Verdad’s analysis further reveals a decline in profitability for both large and small listed companies over the past two decades. The drop has been more pronounced for small caps, driven by the diminishing quality of new market debuts. The increasing proportion of financial and biotech stocks among smaller American stocks, traditionally less profitable sectors, has exacerbated the difference in leverage between large and small companies.
The concerns raised by industry experts have implications for investors seeking value in small-cap stocks. Despite the recent positive signs in the Russell 2000, analysts caution that the challenges extend beyond short-term fluctuations. The changing dynamics of the market, fueled by technology and private equity, raise questions about the long-term viability of small-cap equities. As the best startups opt to remain private for extended periods, small-cap investors may find themselves with a limited pool of attractive investment opportunities, reflecting a broader trend of declining public debuts and a shrinking universe of small-cap stocks.
In the intricate dance between S&P 500 giants and small-cap stocks, the market’s evolution remains uncertain, as recent rallies and challenges underscore the ongoing dynamic interplay between these two pivotal segments.
Source: Bloomberg
