Global Perspectives: Can momentum in small caps continue?

Lara Castleton: Hello and thank you for joining this episode of Global Perspectives, a podcast created to share insights from our investment professionals and implications they have for investors. I’m your host for the day, Lara Castleton. Today we’re digging into small caps, arguably one of the most controversial topics in our portfolio consultations today. After years of large cap dominance, we’ve started to see glimmers of small cap outperformance in late 2024 as a Fed rate cutting cycle is upon us. But the path has not been smooth, and there’s still many questions on whether small caps can sustainably outperform their large caps.

To get into the discussion, we need to set up why the macro environment today may be conducive for small caps to outperform, but also discuss why and where to maintain caution. And to do this, I’m thrilled to be joined by two of our small cap experts, Jonathan Coleman’s Midcap portfolio manager on our SMID cap growth team and Justin Tugman, portfolio manager on our SMID cap value team. Gentlemen, thank you both for being here.

Coleman: Thanks for having us.

Castleton: So Jonathan, repeat on the podcast. Let’s go to you first. Can you just explain the recent momentum behind U.S. small cap stocks? What’s really sparked this?
Jonathan Coleman: Well, this really all started around July 10th when we had a softer than expected inflation print and that kind of opened the door for the possibility of rate cuts, which investors had been heavily debating about the timing and the magnitude of. And since that point, as of today when we’re filming this on September 10th, the Russell 2000 index has outperformed the S&P 500 by about 500 basis points and importantly the MAG 7 stocks by about 1700 basis points. So we’re starting to see kind of a change in tenor of the market.

And then I think you hit upon a really important point in the intro, which is the duration of large cap outperformance has been so long. We’re kind of in the 13th to 14th year of outperformance of large cap. All good things must come to an end if you’re a large cap investor. And if you look back over the long course of history, there have been alternating periods of small cap versus large cap outperformance that tend to go in waves of about 8 to 14 years. So it feels as if we could be setting the stage for a change in leadership in the market.

Castleton: So this rotation has started to happen since July. It has been a very long time with large caps outperforming. Justin, what do you think are the macroeconomic and fundamental backdrop today that would have small caps potentially switching and outperforming for a sustainable period?

Justin Tugman: Well, I think when you look at what we’re starting to see in the market now, it’s the fact that inflation is coming down. Historically when we’ve had inflation above 3% and declining, that has been a good environment for small caps. When you are now looking at the potential for Fed rate cuts, lower interest rates, the balance sheets are typically a bit more levered in small cap names. So that’s a benefit to the bottom line, lower interest expense and therefore that helps the earnings. So those are some of the fundamental backdrops that I think are setting up very well for small caps. And I think when you look at the overall landscape domestically, our economy continues to do better than a lot of the rest of the world. With small caps, you get a lot more domestic exposure. That could certainly be another catalyst for this group going forward.

Castleton: OK. So we’ve had some good outperformance as of late. Jonathan, thank you for sharing those numbers. Valuations are consistently a hot topic within small caps. We’ve heard how undervalued they have been versus their large cap counterparts. Even after this run today, how are you viewing valuations in the small cap market? Is there still opportunity in that space?

Coleman: Our observation is that the setup is still very favorable for small caps. If you look over the long course of history, small caps today are in about the 16th percentile of relative
valuation compared to large caps. And then I think very compellingly, when we look back at today’s relative valuations of PE ratios of the small cap universe compared to the large Cap universe, looking five years prospectively in terms of returns. When we have had this level of valuation in the past, the smallest amount by which small caps have outperformed is 500 basis points annualized over the next five years. So we think that’s a very compelling setup. And then perhaps even looking more short term, we had an extreme burst of outperformance coming off that inflation print that I referenced earlier. In fact, small caps appreciated by 10% / a five-day period of time that has happened 17 times in the past in stock market history. And all 17 times that that has occurred in the past, small caps have been up 12 months after that initial burst of outperformance. So you know, history’s never exactly repeats itself but we think historical precedent is very attractive for the set up for small cap both in kind of the intermediate and longer term.

Castleton: That’s very interesting because that is one of the questions we get consistently is after you’ve started to see some of these outperformers, the questions always, am I too late?

Coleman: Right. Have I missed it?

Castleton: Exactly

Coleman: I think not.

Castleton: We are entering into a new environment. It is inflation coming down, we’ll get CPI soon, but the Fed cutting rates that’s very different than raising over the past couple of years. Now seems to be a really nice inflection point to be looking in areas with cheaper valuations and small caps. So Justin, is it just as simple as going for the cheap beta in that space and you can get blanket exposure to the index in general or is there a reason that we need to be a little more selective in the space?

Tugman: When you look, historically speaking, it’s very important to frankly take an active approach regarding small caps. There will be periods where high beta, high leveraged stocks, low quality stocks outperform. But historically speaking, that has not been a winning game plan going forward. And so when you start to look at the valuations, the quality versus lower quality, low quality is actually expensive; trades at above 4 times revenue, you see that’s almost twice as expensive as the higher quality in terms of revenue basis.

I also think that when you are starting to look at this point in the cycle, there’s 36%
of the components of the Russell 2000, that are still money losers. And frankly that’s a bit unnerving given that we’re this late in the economic cycle that you have that many money losers within the benchmark. So what we have found over time in terms of looking at historical data is that you want to own high quality companies with strong balance sheets, consistent free cash flow generation and well managed companies. And so look at things like high ROE companies, high ROIC companies. The management teams that do a very good job of investing the shareholders capital, make smart non-expensive acquisitions. That’s how you outperform in small caps over the long term. And we think that when you start to factor that in with the valuation, quality certainly makes sense within the small caps right now.

Castleton: It is one of the concerns we hear from investors on small caps is the amount of unprofitable companies in the space. And many investors are still worried that
we may not have fully agreed upon the soft landing, that there may be something to happen
on the other end. So can you kind of go into your value universe a little bit more so you’re on the SMID cap value side. How does that quality help if there is some uncertainty in the economic environment going forward?

Tugman: It’s absolutely critical. First of all, it allows the flexibility to the companies in terms of how they can operate throughout the cycle. We don’t have to worry as much about balance sheet. And if they have a good balance sheet, if interest rates do happen to go up, they can withstand that extra interest cost. They’re not highly levered and then in effect they’re not as dependent upon capital markets for financing.

That’s how you get diluted as a shareholder when the company’s mismanaged the balance sheets. So that and the consistent free cash flow generation, those are the type of companies that can withstand any economic cycle. That’s what you want to own over the longer term. I think when you also look at those companies that do a very good job of investing the shareholders capital and whether it’s a creative M&A, whether it’s buybacks, those are the ones that can actually compound value over time.

Castleton: That’s one of those things maybe investors can get access to the small cap universe. They may not get as much of that immediate beta balance, but they’re more resilient if there is some uncertainty by going into the right type of exposure
in the space. And so as a growth investor on the small cap side, I guess similar question to you, how do you approach growth investing in small caps today?

Coleman: Well, even though Justin and I may be on slightly opposite sides of the spectrum, I’d say we have extreme philosophical agreement in the types of things that we’re looking for. And really what he said, I would echo wholeheartedly. Among them, active really matters in small cap because it is a very heterogeneous universe of publicly listed companies, some of which I always like to say are on their way to becoming midcap and large cap overtime. And that’s something that we celebrate as small cap investors because it means our clients have made money, others of which are destined to remain small cap forever because they’re relatively undifferentiated. They may be money losing, they may have poor management teams and poor capital allocation. And so focusing, you know, my perspective is maybe slightly different in that we’re looking for slightly faster growth, we’re looking for highly innovative companies, but companies that are still profitable,
that control their own destiny, that produce strong free cash flows.

The only element I would add that Justin didn’t add, which I’m sure he probably agrees with, is companies that have a high predictability or recurring nature to their revenues, because that’s what’s really helpful in uncertain economic times. You know, I think we are humble enough to know that we cannot predict the economy’s future. Economists can’t even seem to predict that with high degree of certainty. But if you have a company or business that has lots of recurring revenue, so you don’t have to fill up that bucket every single quarter, or single year in terms of your revenues, that will generate cash flows, that is very helpful and it results in lower volatility of the stock.

Castleton: I do think it would be worthwhile to get your sense of what you do expect. Granted, we know we don’t have our crystal balls, but from both of you, how do you view the economy? The soft landing, hard landing question? What’s your outlook?

Tugman: We think there’s probably a greater chance that we’re going to see what we might call rolling recessions. We’ve started to see it in the industrial space a bit. There’s been some slow down there, but it hasn’t been widespread throughout the economy. I think when you start to look at the consumer, you started to see a slowdown at the low end and it may be moving its way to the more middle-income consumer.

I think what we’ve seen in terms of what companies have said is that some of the higher income consumers are also trading down. So it seems like we’re having kind of this rolling recession and we’ve seen something similar to it in 2016 where we had an industrial recession, but the economy never truly went into a recession. We still think that there’s reason to be optimistic. You know, I think when you think about Fed rate cuts, if it’s done in a, I guess, relatively gradual fashion, I think that’s something that can certainly be healthy. If we start to see 6-7 rate cuts quickly, that probably means there’s a bigger problem out there. If it’s done in a methodical manner, I think it would be very healthy for the stock market and particularly small caps in general.

Castleton: Jonathan, what do you think?

Coleman: I think we’re in a slow growth economy. I think the cumulative impact on monetary policy of the last couple of years is starting to bite in a number of areas, you know, going from zero to 5 1/4%. So I do think that the economy is facing some headwinds. However, I think now that Chairman Powell, in the last 18 months or so of his tenure as Fed chair, he’s going to be thinking about his legacy. And we seem to have made significant progress in lowering inflation from the over 9% peak now to below 3%. And you know, we’ll see what the future prints hold. But the direction of travel is, is positive. And I think that he is going to want to pivot to focus on protecting a slightly weakening employment environment, which we’ve started to see show up and some of the government data. And so I think the Fed is likely to be more accommodative going forward and I think it will be supportive, but for economic growth and for the market.

Castleton: Is it safe to say that regardless of what might happen, you still find a good backdrop for investors to have some exposure to small caps?

Tugman: I think our ability to predict the economy is no better than anyone else as Jonathan alluded, but there’s, there’s always a bull market somewhere. And so it’s our ability to find those areas where you know, from a value perspective where the names are kind of seemingly washed out, the valuations are attractive and where sentiment is, is poor. Those are where the opportunities lie. And so there’s always opportunities. We certainly see them today, despite some of the more sluggish economic data that we’ve been getting.

Coleman: We always say when we go into owning a position, we want to know that we can own a company through an economic cycle because we can’t predict the economic cycle. And so that’s where I hearken back to the kind of the resiliency of the business model of the cash flows, recurring revenue nature of companies that we find attractive. You can own those types of businesses without certainty about what the economic future is. So that’s what we focus on.

Castleton: That’s great. Thank you. I do want to now shift focus and go into some of the more granular themes within both of your spaces. So I’m going to ask both of you, but I do have to address AI because it is the biggest theme dominating most headlines today. So Jonathan, I want to start with you. Just what are some of the themes you’re most excited about in the small cap growth space? But then also can you address how you view AI?

Coleman: A couple themes that we like at kind of a high level would be the trend towards deglobalization. You know, we’re seeing trade barriers increase. We’re seeing major political candidates on both parties that are more protectionist than they have been in the past. And so that is a theme that I think actually plays into the small cap secular narrative here because small cap companies are more domestically exposed than their large cap counterparts. And so if more domestic activity is focused industrially in the United States, that has a whole flywheel series of effects that could benefit small cap oriented companies. And so we think that’s very positive.

Another one is really the connectivity of everything we would call it. And so the fact that data is being accumulated, aggregated, analyzed by companies in all sorts of sectors of the economy. There are many businesses that are benefiting from that. And then that doesn’t really even get into AI, which I know you wanted to ask about and maybe I’ll just tackle it head on. When we look at that space, we really try to think about both first-order beneficiaries of AI and then second-order beneficiaries and then the first order.

An example or two that I would give would be a company that helps catalog data for inclusion in large language models, which is necessary to run all these generative AI programs that people are trialing in large scale today. And so that’s a company that’s kind of a selling pickaxe to the miners. They’re benefiting from the massive amount of investment that’s going into creating LLMs. And then a second order beneficiary would be a company that is a platform upon which physicians take diagnostic notes for the patients that they meet with. We’re aware of a company that allows an AI approach to that, that can dramatically reduce the physician’s time associated with administrative duties, allow that physician to see more patients, provide better care and generate more revenue for his or her hospital.

Castleton: That’s great. Sounds like the intention of what it’s supposed to do is to increase productivity. Thank you for that. Justin, what about you within the value side of your small cap universe? What are some of your favorite themes? And then any comments on the AI in general?

Tugman: Yeah. Well, much like Jonathan, we’ve been big on the reshoring to the US theme. It started really, I think when you go back to when Trump first got into office, and we started seeing tariffs. You started seeing companies moving production around from whether it was China to Vietnam, other areas, but then some of it was coming back to the US. Think that has certainly accelerated in the past three or four years. Part of it was COVID, but the other big chunk of it has been huge amounts of government spending and stimulus to get more manufacturing back in the US. I think regardless of what administration we have going forward, that’s going to continue. I would also say that one of the areas that we have been very positive in our portfolio has been within financials, both insurance and banks, especially insurance. It’s not the most glamorous industry, but I think anyone who’s owns a home or owns a car, you’ve seen what’s gone on with the prices of insurance and that is going to the bottom line now. There was certainly a period where a lot of the insurance companies were caught between inflation and the lack of premium growth, but you’re seeing that premium growth now go down to the bottom line.

And so we’ve liked the insurance space for quite a while here. The other area within financials has been banks. Go back 18 months when we had a banking crisis, it was painful. No one wanted them. Don’t get me wrong, I think if we have a slowdown, we’re still going to have some credit issues out there. But certainly, I think when we look at the valuations, a lot of those are priced in and you are seeing a lot of consolidation now within the small cap banks. So that’s those are, you know, two themes that we’ve liked regarding AI and the value side. There’s really not as many opportunities.

Now that said, within our portfolio, we’ve actually benefited from several companies. One of them they provide cooling for data centers. It’s a stock that we owned for several years, but it wasn’t because of AI. It was because of the large amounts of infrastructure that are being built, whether it’s factories or after COVID, a lot of spending to redo HVAC systems. And now that it has gone to the data centers, it’s been an enormous success for them. I think the other area has been within some of the companies that build the equipment for the data centers. We’re starting to see large amounts of money flowing into that space.

And so there are ways you can benefit. I would also say, though, that there are certainly those companies that are being disrupted by AI. And so it’s really something that we have to focus on in terms of trying to avoid those that may come under the negative connotation of what AI could do to them.

Castleton: It seems like AI is really spreading its wings to every area of the market and it just becomes all that more important to be able to have that focus on where it’s going to disrupt or what the winners will be in that space. But also thank you for walking through some of those specific sector examples within your space that are maybe outside of that as well. I guess just to finalize this, for most clients that we work with, they have a large exposure to the large cap universe. It is most likely one of their heaviest weights within their portfolios, but I’d love to just hear final comments on why small caps are worthy of some more attention today versus those large-cap overweights.

Tugman: There’s the old hockey analogy. You want to go to where the puck is going, not where it is now. For the fact that small caps have been effectively kind of been the redheaded stepchild for the past 10 plus years, it presents a good opportunity and a way to diversify your portfolio, shift some potentially some of the profits from large cap into an area where we certainly think it’s set up to outperform going forward. And it diversifies the portfolio, right. You don’t have as much international exposure. And I think that there are certainly opportunities to dramatically outperform within small caps given some of the quality characteristics of the benchmarks. And I think if you are willing to do active management, I think that’s where you can really generate a lot of alpha within small caps.

Coleman: I think the perspective I’d bring to that, just to add to what Justin said, is that
we’ve seen periods of extreme concentration in the large cap market a couple times in stock market history. One was the Nifty 50 in 1973-74, the kind of the Internet 1.0 bubble in late 1999, and then in the current era with the Mag 7, and it has a slightly different flavor each time. But when you get this crowding into 5-7-10 stocks and they’re the must own stocks and all investors universally agree that those are the only stocks to own and they’re safe and they’re going to do well forever. Generally speaking, that’s towards the top of that cycle. And it doesn’t take much in terms of money flowing out of some of the mega cap stocks and flowing into small caps to dramatically elevate and lift the small cap market. And so as an extreme example, you know, if you take two or three basis points out of the aggregate ownership of Apple that will buy the median stock in the Russell 2000 index will buy 100% of it.

Again, it doesn’t take a whole lot of money flowing out and going into small caps to get a dramatic lift in the index as a whole. And so that’s one of the reasons that being a student of history, I’m excited about where we are historically. It’s been a little bit of a painful time to be a small cap investor, but it feels as if the conditions are ripe for a change of leadership.

Castleton: Yeah, well, thank you both. That’s definitely setting up a compelling case for small caps. It is often said that the next decade will likely not look exactly like the last. So appreciate you walking through all of this. We hope you got some takeaways today
in terms of how to capitalize on the changing guard, in terms of how to invest going forward and saw that small caps, especially when you’re using active management, can be a great way to diversify from the winners of the past.

Thank you for joining this podcast. I’ve been your host for the day, Laura Castleton. For more insights from Janus Henderson, you can download other episodes of Global Perspectives wherever you get your podcasts or go to janushenderson.com. Thanks. See you next time.

Basis point (bp) equals 1/100 of a percentage point. 1 bp = 0.01%, 100 bps = 1%.

Beta measures the volatility of a security or portfolio relative to an index. Less than one means lower volatility than the index; more than one means greater volatility.

Free cash flow (FCF) yield is a financial ratio that measures how much cash flow a company has in case of its liquidation or other obligations by comparing the free cash flow per share with the market price per share and indicates the level of cash flow the company will earn against its share market value.

Price-to-Earnings (P/E) Ratio measures share price compared to earnings per share for a stock or stocks in a portfolio.

Return on Equity (ROE) is the measure of a company’s annual return (net income) divided by the value of its total shareholders’ equity, expressed as a percentage. The number represents the total return on equity capital i.e., the profits made for each dollar from shareholders’ equity.

Return On Invested Capital (ROIC) is a measure of how effectively a company used the money invested in its operations.

Russell 2000^® Index reflects the performance of U.S. small-cap equities.

S&P 500^® Index reflects U.S. large-cap equity performance and represents broad U.S. equity market performance.

Volatility measures risk using the dispersion of returns for a given investment.