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Opportunity in Small Caps? (ALPSadvisors)

Over the past several years, the US stock market has been characterized by the relative outperformance of large cap stocks driven by concentration into the largest growth stocks in the S&P 500 Index. The chart nearby of small cap vs. large cap returns over the past 20 years highlights that disparity. 20221220-chart-1Over the 1, 5, 10 and 20-year periods, the S&P 500 has outperformed the Russell 2000 by a significant amount. This has manifested itself for the most part over the past 10 years. 

During this past summer, as the US dollar rallied, small caps outperformed large caps by approximately 500 basis points between May 1, 2022 and October 31, 2022.1 To some extent, it appeared that the strength in the US dollar during that period would benefit small caps relative to large caps as the latter are much more dependent on international sales. Since then, the dollar has weakened, calling that catalyst into question. Since October 31 as the overall market has sold off, there has been what appears to be a flight to quality into larger cap equities. 

So has the small cap opportunity effectively ended?

In Small Caps, Quality is King

In our view, there are opportunities available if small cap investors focus on quality. An important characteristic of the small cap universe is the prevalence of unprofitable companies. Using Bloomberg data as of December 8, approximately 40% of the companies in the Russell 2000 Index had negative earnings-per-share over the previous 12 months compared to about 5% of the S&P 500 Index.1

After excluding unprofitable companies, let’s compare the two index valuations (medians):
20221220-chart-2From both a Price/Earnings Ratio and EV/EBITDA perspective, the median small cap appears cheap relative to large caps. 

Taking this one step further, in a market like today’s where the cost of capital (rates) is increasing, cash flows that are near term are more attractive than cash flows far into the future. In the equity market, dividends are the nearest term cash flow you can get. If we further slice the data into just companies in each index that pay dividends, small caps also stack up reasonably well:
20221220-chart-3The median small cap stock in this smaller universe also trades at 13x earnings, vs 20x in the large cap dividend payers.1 In our view, if an investor is selective, there remains an opportunity to own relatively high quality small cap dividend-paying stocks at a discount to their large cap brethren.

Important Disclosures & Definitions

1 Bloomberg, 12/08/2022

Performance data quoted represents past performance. Past performance is no guarantee of future results; current performance may be higher or lower than performance quoted.

Basis Point (bps): a unit that is equal to 1/100th of 1% and is used to denote the change in a financial instrument.

Enterprise Multiple (EV/EBITDA): a ratio used to determine the value of a company by considering the company's debt. The enterprise multiple is the enterprise value (EV) (market capitalization + total debt – cash and cash equivalents) divided by EBITDA (earnings before interest, taxes, depreciation and amortization).

Price/Earnings (P/E) Ratio: a valuation ratio of a company's current share price compared to its per-share earnings.

Russell 2000 Index: measures the performance of the small-cap segment of the US equity universe.

S&P 500 Index: widely regarded as the best single gauge of large-cap US equities. The index includes 500 leading companies and covers approximately 80% of available market capitalization.

AAI000202  03/31/2024

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