Small no longer looks quite so beautiful; The opportunity to enter the rally in smaller companies has passed

November 13, 2013 9:07 am

Small no longer looks quite so beautiful

By John Authers

The opportunity to enter the rally in smaller companies has passed

Size isn’t everything. Indeed, of late, lack of it has been highly profitable. Small-capstocks have readily outperformed larger stocks all year, and have done so since the post-crisis rally began in March 2009. The question now is whether the rally can possibly have more legs.Anybody trying to deny that it is too late to join the small-cap bandwagon certainly has a tough job on their hands. First, looking at market dynamics, the scale of small-caps’ outperformance looks unsustainable.

Over the very long term, smaller companies tend to outperform. Academic studies have demonstrated this exhaustively. But they rarely fare as well as in the recent environment. According to the Russell indices, widely used as the benchmark for smaller companies in the US, the Russell 2000 index of small-cap stocks has outperformed the “Top 50” of mega-cap stocks by 163 per cent since the beginning of 2000. The 2000 has gained 118 per cent since then, in price terms: the Top 50 is down, remarkably by 18 per cent since then.

More recently, it has outperformed by 37 per cent since the beginning of the relief rally. And the lead for small-caps has widened this year. The Russell 2000 has made a total return of 31.1 per cent for the year so far; the Top 50 has returned only 22.9 per cent. According to Goldman Sachs, the Russell 2000’s performance, both in absolute terms and relative to bigger stocks, is more than a standard deviation above its long-term mean.

The picture is the same in developed Europe, where Russell’s indices have small-caps gaining 28.5 per cent for the year in dollar terms, against 17.8 per cent for large-caps.

Added to this, small-caps have been the flavour of the year so far for US retail investors, who have a painful history of providing good contrarian indicators, buying at the top and selling at the bottom. So far this year, according to Goldman, flows into small-cap mutual funds and exchange traded funds have run at $22bn, or 5 per cent of total assets under management, which is on course to be their best year on record. Meanwhile, institutions have a longer position on Russell 2000 futures than at any time since the data started in 2006.

Finally, when looking at fundamental valuations, smaller companies look stretched. According to Morgan Stanley, they trade at 18 times expected future earnings, compared with 14.1 times for mega-caps.

Even if momentum can keep small-caps trundling upwards a bit longer, all of this suggests that the opportunity to enter small-caps has passed.

Rate advantage

And yet, intriguingly, equity strategists at both of Wall Street’s dominant investment banks, Goldman Sachs and Morgan Stanley, have published notes this month arguing that the outperformance can carry on. Cynics can happily take this as a contrarian selling signal, and their choice of subject reveals much about the questions that their clients have been asking; but the arguments need to be addressed.

According to Adam Parker of Morgan Stanley, small-caps can keep outperforming because their profitability remains below the long-term average. For large-cap stocks, as is widely noted at the beginning of most bearish cases for the market, profit margins remain at or close to historic highs. They seem overdue to revert to the mean. For small-caps “the dream of future margin expansion is still alive”, which he argues, could come from rising factory utilisation and increased labour productivity.

Then there is the prospect of sales growth. Small-caps actually have some growth in their top lines (5.7 per cent year on year as of the second quarter). For the last three quarters, mega-cap companies have not.

As for debt, smaller companies naturally tend to be more highly leveraged, which is a big part of their outperformance in an era of exceptionally low interest rates. Small-caps would seem to be a perfect candidate to be punished by the market when interest rates make their eventual rise (even if the Federal Reserve chooses to keep postponing that moment). But Mr Parker points out that debt-based measures are perverse for small-caps, meaning that since 1976 the most heavily levered companies’ share prices tend to outperform the least levered.

As long-term interest rates trended sharply downwards over most of this period, it must be highly questionable whether leverage would keep having such a perverse effect when and if rates start to rise significantly. But, as Goldman’s David Kostin points out, the perverse relationship was strongly in force even as “taper talk” pushed up yields earlier this year. It was during the period when 10-year yields rose from 1.7 to 3 per cent that small-caps clocked most of their outperformance for the year.

Animal spirits

Finally, Mr Parker points out, there are deals. Large-cap companies have a lot of spare cash, and small-cap companies by definition are easier to buy than larger ones. If animal spirits finally return to the deals market, it is reasonable to expect small-cap stocks to benefit.

For Mr Kostin, focusing on the US, the argument rests on US economic growth. Smaller-cap companies, almost by definition, are more strongly exposed to the US, and the conventional wisdom remains that the US is poised to grow more strongly than anywhere else. Mega-caps’ international diversification becomes a millstone. The consensus earnings expectation next year for the Russell 2000 is 33 per cent growth, compared with only 11 per cent for the S&P 500.

But, as he points out, this argument could yet move into reverse. Stronger growth outside the US, and a weaker dollar, could make big US multinationals look stronger once more.

There are arguments for smaller caps to keep performing. But it seems highly likely that most of their outperformance is now in the books. Rather than just buying a Russell 2000 ETF, opportunities in the sector will now most likely depend on spotting those companies that are most likely to be bought, and those that have the best chance to raise their profit margins.