What makes U.S. small caps attractive in 2024?

Jonathan Coleman:  I think it’s an interesting time to consider small cap stocks or an allocation to small-cap stocks because we’re at historic levels of relative valuation and underperformance of small caps versus large caps. And these cycles tend to go in periods of about eight to 12 years, and we’re in, arguably, the 12th or 13th year of a cycle of underperformance of small-cap stocks. So, I think, from a historical perspective, it’s quite interesting to look at the possibility that small caps could be poised for better outperformance.

And then when we look at valuations on a relative basis to large caps – we’ve done a lot of retrospective analysis and going back to 1930, so, over 90 years – we’ve seen these levels of relative discount of small caps to large caps only about three other times in history. History does not always repeat itself exactly, but it often can rhyme. And so, at these levels, we have often seen small caps start to outperform large caps.

Another element that I think is quite interesting is that small caps have already reflected what is, could be perceived as a reasonably dire economic outcome. And so, when we look at the small-cap index, the benchmark is down over 30% from late 2021 to its October 2023 lows. And those are levels that have been pretty predictive of trough levels when you look at a bear market for small caps over time.

What risks do small caps face if economic growth slows?

I think the risks are mitigated by the relative underperformance that we’ve had and the absolute underperformance. I do think it’s important to note that small caps are more volatile than large caps, and therefore, in drawdown periods, the beta of the small cap market is higher than that of the large-cap market. But I think what has happened, as I just discussed, is that the underperformance has been pulled forward earlier than we’ve had in large caps.

One of the interesting things about the length of this drawdown, is that the period has lasted about 700 days. If we look historically at bear markets in the small-cap space, they last a little over 300 days. So, historically, this is a very long period of drawdown and perhaps we have seen the bottom, and that might argue for better performance in 2024.

Another thing that I find very compelling is that when small-cap markets have entered into bear market territory and they break out of them, the prospective returns are very attractive, both absolutely and relative to large caps. And so, historically, the average, since-1980 historical performance of the U.S. small cap market is +60% in the 12 months after the bottom of the bear market, and that has exceeded the performance of large caps by over 20 percentage points.[i] So, I think the risk/reward seems to be tilted in favor of small caps when we look prospectively as to what the future might hold.

What long-term growth themes are you watching?

I think it’s really interesting to look at the positioning of the big geographical areas of the market and think about what the next several years might hold. I think the U.S. is relatively well positioned internationally. We have a reasonably robust economy. We have good demographics in our favor; not perfect demographics, but better than most of the other regions. And then, by investing in small-cap companies, you get more exposure to the U.S. economy than you do with global multinationals and U.S. large caps even.

And then we add on to that some additional secular drivers that I think are positive. So, this dynamic of the undoing of globalization – the deglobalization of supply chains, oftentimes referred to as onshoring. If we bring production back to the United States, that is going to help small-cap companies disproportionately because they have that higher exposure to the U.S. economy.

And then I think it’s also really an interesting time to be an active investor because in periods of these regime shifts and uncertainty, there are opportunities created, and that’s one of the things I’m excited about for 2024 and beyond.

What is the biggest risk to small caps now?

I think the biggest risks that we see in small caps is what we would call a bifurcated market. So, you do have some small-cap companies that are still very highly valued on multiples of revenue. Many small-cap companies in the publicly listed market are still unprofitable. And again, we think this argues for an active approach to picking stocks within the small-cap universe.

In contrast, we also, the other kind of half of this bifurcated market is that we see a whole universe of companies that are trading at historically low valuations, both on a relative and absolute basis. So, we’re quite excited that we can find companies that we think can compound their revenue and cash flows at reasonably attractive rates that are trading at multiples that we haven’t seen in over 15 or 20 years.

What’s the key takeaway for small-cap investors in 2024?

I think it’s don’t give up. Being a small-cap investor has been tough over the last decade-plus. There have been lots of reasons to kind of give up on the asset class. But when all hope has left the building and it seems it’s the worst time, that’s oftentimes the best time for prospective returns, and so, I’m quite excited about that as I look forward.