Key Questions: “You’re Killin’ Me Smalls!” Will Small Caps Ever Outperform Again?

Does the recent rally in small caps have room to run?

Over the past three years, small caps have underperformed large caps by the widest margin (-50% underperformance) since the dot-com bubble. Following a powerful rally in small-cap equities over the past several trading sessions, investors may be wondering whether this rally will continue and if adding exposure to this asset class makes sense.

For over a decade, having minimal exposure to small caps has generally been a wise asset allocation decision. However, looking over a longer time horizon, relative performance between large-cap stocks and small-cap stocks tends to transcend over multi-year cycles, spanning anywhere from five to 10 years. Currently, we are in the 11th year of small-cap underperformance.

While this period of small-cap underperformance is on the longer end of historical norms, that in and of itself is not a reason for the trend to change. That said, in the following paragraphs, we explore some of the reasons this trend has been so persistent and whether the above-mentioned recent rally is the start of a new small-cap leadership cycle or if it will be short lived. 

Cost of Capital

Small-cap companies generally have a higher cost of capital (i.e., higher borrowing costs) than their large-cap counterparts, as they are commonly viewed as riskier companies that may be unable to repay their debts. The spread between the interest rate a large-cap company pays and small-cap company pays fluctuates based on a variety of macroeconomic and company-specific factors. However, prior to this recent rate-hiking cycle, the real interest rate the highest-quality large-cap companies paid was near zero. [Real interest rates are interest rates after inflation.]

And with essentially free money, many large-cap companies were able to invest to grow their business with minimal risk, expand to choke out the competition, and be the largest buyers of their own stock given the instant return potential and the spread between cost of debt and cost of equity. All the while, small caps had to be far more judicious when making investments. They were also on the receiving end of large-cap companies’ competitive tactics and they could not repurchase shares at nearly the rate of large-cap companies, given the high costs associated with it. 

Rise of Passive Investing and Private Capital 

The cost of capital disparity between large- and small-cap companies that has helped drive large-cap outperformance was also exacerbated by the rise of passive investing and private equity/venture capital.

Large-cap passive investing has turned into a virtuous cycle of sorts. As these companies took advantage of their cost of capital advantage, equity prices outperformed. This led to more passive assets flowing to large-cap companies, which caused further equity price outperformance and lowered their cost of capital even more.

The private equity industry also took advantage of low financing costs to buy high-quality, but low-growth businesses with a lot of leverage. Despite high leverage, low interest rates made the financial math work and private equity firms were able to cuts costs and/or improve operations and earn a strong return on investment. Historically, this type of PE turnaround situation may have taken place on the public markets, where cost of equity is generally lower due to better liquidity.

The venture capital industry also took advantage of low interest rates as VCs were able to fund innovative, high-growth companies, helping them stave off the need to go public until they are much more mature. This left the most rapid period of growth and value creation to occur while the companies were private. This in turn has created a dearth of smaller innovative companies being publicly traded. 

While it is difficult to show precisely the performance detriment suffered by small caps due to these factors, looking at the number of equity and fund listings in the U.S. helps paint the picture. In 1996, more than 8,000 U.S. equities and 6,300 mutual funds and exchange-traded funds (ETFs) were listed, according to the World Bank.¹ By 2022 the number of equities was down to 4,600 and the number of funds nearly doubled and has surged to 11,700. This illustrates that that there are far fewer public equities to invest in and many more funds that allow investors just to buy a basket of securities. 

Where Do Small Caps Go From Here? 

Following the softer than expected inflation reading on July 11, small caps have begun to outperform large caps. Softer inflation readings mean investors believe interest rates cuts will occur sooner than previously expected, and this benefits small caps in two main ways: First, lower rates mean lower interest expense and therefore highly levered small caps can grow earnings at a faster rate as their cost of debt comes down. Second, there tend to be more unprofitable, higher-growth small caps, which can be considered longer-duration assets. As rates decline, the discount rate investors use to value future cash flows also comes down, in turn increasing the intrinsic value of the asset in today’s dollars.

The anticipation of a rate-cutting cycle may continue to drive small-cap outperformance near-term. However, to see a more lasting regime change in small caps' favor, we need not return to the “free money” era of the 2010s. Stable but higher rates will be good for small caps for the same reasons near zero rates plagued them the last decade. Higher rates could weed out below-average private capital managers, allowing more companies to return to the public markets. While large caps will always have a rate advantage, when money isn’t "free," there are more trade-offs for a company to consider, which could level the playing field between small and large caps. 

How Do I Invest in Small Caps? 

Given the higher risk and volatility associated with small caps, buying individual securities may not be the optimal strategy. Buying index funds that track small-cap indices may not be the best approach either, given many of them contain upward of 2,000 securities.

On the other hand, selecting a skilled active manager who employs a diversified but concentrated approach to small-cap portfolio management may be the best way to gain exposure to small caps, while having the opportunity to generate alpha.

Over the past five years, an average of 56% of U.S. small-cap managers were able to outperform the benchmark on an annual basis compared to only 41% of U.S. large-cap managers, according to Jefferies.² While picking an active manager that outperforms year after year is never a sure thing, your odds of success are higher in small caps based on recent history.