Small Caps: The Hidden Opportunity in a Slowing Economy

In the ever-evolving landscape of the stock market, small-cap stocks often find themselves in the shadows of their larger counterparts. However, as the economy begins to slow, these smaller companies may present a unique opportunity for investors. The current economic conditions, including slowing growth and potential interest rate cuts, are creating a favorable environment for small-cap stocks to outperform large-cap stocks. Let's delve into why this is the case and which sectors within the small-cap space are likely to benefit the most.



The Case for Small-Cap Stocks

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. This phenomenon, known as the small-cap premium, 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.

One factor that has contributed to the recent disappearance of a small-cap premium 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. This has led to a situation where the S&P 500 has outperformed the Russell 2000, a small-cap index, by a significant margin over this period.



The Impact of Interest Rates

Small and SMID-cap companies are more sensitive to short-term interest rates because they carry twice as much debt as their larger counterparts. This sensitivity is highlighted by the fact that Russell 2000® companies have an average net-debt-to-EBITDA ratio of 3.3, compared with 1.6 for S&P 500® constituents. This means that small-cap companies are more vulnerable to the cost impact of higher interest rates, which can drag on their balance sheets and profitability.

However, if the Federal Reserve (Fed) eases rates as forecasted, it could pave the way for a more growth-conducive monetary policy framework. This could potentially improve sentiment toward smaller-cap stocks in the coming months. The potential for interest-rate cuts on the horizon, combined with valuations at historic lows relative to large caps, suggests that smaller caps may offer significant alpha opportunities for investors.

Sectors to Watch

Within the small-cap space, certain sectors are likely to benefit the most from a slowing growth economy. Greg Garabedian, Smid/mid-cap value Equity Portfolio Manager, highlights that smid- and mid-cap value companies offer more diverse sector exposures compared to large-cap counterparts. He notes that "Smid- and mid-cap value offer more diverse sector exposures than large caps, where more than 40% of the S&P 500 Index weighting comes from IT and communication services." This diversification can be beneficial in a slowing growth economy because it reduces reliance on a single sector and spreads risk across multiple sectors.

Additionally, a broadening of economic growth and/or slowing of AI capex activity could relatively benefit more diversified smid-cap exposures in areas like financials and industrials. These sectors are likely to see increased demand as the economy slows, making them attractive investment opportunities.

Conclusion

In conclusion, the current economic conditions, including the potential for interest rate cuts and the historic low valuations of small-cap stocks, create a favorable environment for small-cap stocks to outperform large-cap stocks. While small-cap companies are more sensitive to interest rates and carry higher debt levels, the potential for a more growth-conducive monetary policy framework could improve their performance in the coming months. Investors looking to diversify their portfolios and capitalize on the growth potential of small-cap stocks should consider allocating a portion of their investments to this asset class.

Ask Aime: Why are small-cap stocks expected to outperform large-cap stocks in the current economic conditions?