Asset Allocation Bi-Weekly – Small Caps and the Hope for a Soft Landing (6/24/24)

Small cap stocks may be poised for a rebound. Associate Market Strategist Thomas Wash joins the podcast to explain why.

What is Confluence Podcasts?

Podcasts from Confluence Investment Management LLC, featuring the periodic Confluence of Ideas series, as well as two bi-weekly series: the Asset Allocation Bi-Weekly and the Bi-Weekly Geopolitical Report (new episodes posted on alternating Mondays).

Phil Adler: 00:04

Welcome to the Confluence Investment Management biweekly asset allocation report for June 24, 2024. I'm Phil Adler. Small cap stocks may be poised for a rebound. Confluence Investment Management Associate Market Strategist Thomas Wash joins us today to explain why. And Thomas, just to make sure we're all on the same page, let's first define small caps.

Phil Adler: 00:27

What is the accepted definition?

Thomas Wash: 00:30

Thanks for having me, Phil. Small caps are publicly traded firms with market capitalizations ranging from 250,000,000 to 2,000,000,000. Investors buy them due to their potential to deliver strong growth. Consider Nvidia, for example. It started as a small cap stock before skyrocketing to become the 2nd largest company by market cap.

Thomas Wash: 00:51

This highlights the hidden giants within the small cap sector. Now surprisingly, despite their high growth potential, small cap companies often remain overlooked compared to their larger counterparts. In fact, there are more small cap companies than both large and mid cap companies combined.

Phil Adler: 01:10

And do you place small caps squarely within the category of risk assets?

Thomas Wash: 01:18

You know, small cap stocks often get a bad rap for being riskier than bigger companies like Google or Apple, and this perception isn't without merit. Smaller companies are typically younger, less established, and might not yet be profitable. As a result, they face greater challenges in controlling their prices and securing funding. Small companies often rely more on debt, particularly debt with floating interest rates, meaning their borrowing cost can fluctuate with the market. Estimates suggest that small cap companies have 3 times more of this risky debt compared to larger company.

Thomas Wash: 01:55

Consequently, when the economy takes a downturn, these smaller companies can be hit much harder.

Phil Adler: 02:02

What assets, Thomas, normally compete with small caps for investor dollars? Investors love comparing small cap stocks

Thomas Wash: 02:11

to their bigger rivals, mid and large cap. But here's the secret weapon of small caps. They tend to surge ahead at the beginning of an economic boom, especially when growth starts picking up steam. Why? Because during this sweet spot, many struggling companies get delisted from the small cap index, while some less successful mid caps shuffle down into the category.

Thomas Wash: 02:34

These new additions to the small cap world are often on the upswing with improving sales and outlooks, which gives the entire index a boost when the economy starts to grow.

Phil Adler: 02:46

Moving on now to address our main theme, how have small cap stocks performed this year compared to large company stocks?

Thomas Wash: 02:55

So this year, small cap stocks have been stuck in a holding pattern, neither growing nor shrinking significantly. The primary reason for the stagnation is that investors are waiting on the sidelines for the Federal Reserve to cut interest rates. Now there was a glimmer of hope in the final months of 2023 when the S and P 600, a small cap index, outperformed the S and P 500. Now this uptick followed Dovis comments from Fed members, leading investors to believe that the central bank was planning aggressive rate cuts in the following year. However, high inflation in the Q1 of 2024 and a strong labor market forced the Fed to delay those cuts as they await more evidence that inflation is indeed on a sustainable downward path.

Phil Adler: 03:41

Let's consider factors which may give small caps a lift. Would a cut in interest rates alone be enough for the category to outperform large caps going forward?

Thomas Wash: 03:53

So historically, rate cuts tend to favor small cap stocks. However, to truly thrive, these companies need a few more things working in their favor. First, we need to avoid a downturn. A recession could be devastating for many of these small companies, especially those that are highly leveraged. 2nd, lower inflation is crucial.

Thomas Wash: 04:14

Small companies often have less wiggle room than larger corporations when it comes to absorbing rising costs. If inflation continues to climb, it could squeeze their profit margins and make them less attractive investments.

Phil Adler: 04:27

Which brings me to my next question. Are outsized gains in small caps even possible if inflation remains above the Fed's comfort level and interest rate cuts are delayed further.

Thomas Wash: 04:40

It's important to remember that the Fed has always planned to cut interest rates before inflation falls to 2%. Their latest estimates show inflation won't reach their desired target until 2026. By that time, the central bank projects it will have cut rates by at least 5 times. However, any delay in rate cuts could weigh on small cap companies as investors may be reluctant to take on risk, especially when they can get attractive risk free yields by investing in shorter term securities like t bills.

Phil Adler: 05:12

Well, how about profits? How are small caps doing, and is there reason for optimism?

Thomas Wash: 05:19

Last quarter proved challenging for small cap companies as evidenced by the underperformance of the Russell 2,000, which saw earnings growth of less than 1%, contrasting with the robust 8% growth of the S and P 500. However, it's crucial to highlight that a significant portion of the gains in the large cap stocks stemmed from a select few tech companies. For instance, in 2023, the magnificent 7 witnessed their profit surge by an estimated 29%, while the broader index experienced a notable decline of 4.8%. This concentration underscores that while large cap stocks may seem strong overall, the benefits are disproportionately concentrated among a key few players.

Phil Adler: 06:04

How about small cap valuations, Thomas, compared to large caps? Are they at a level where investors Currently, the S

Thomas Wash: 06:14

and P 600 trades at a price to earnings ratio of 7.5%. Currently, the S and P 600 trades at a price to earnings ratio of 17 compared to its large cap counterpart, the S and P 500, which sits at nearly 25. This represents the widest valuation gap since the dotcom bubble, which historically preceded a period of outperformance for small caps. Now valuation isn't the only factor that drives the market. There's momentum, size, and profitability to consider too, But we believe valuation will become even more important as investors get less excited about big established companies and the overall financial climate improves.

Phil Adler: 06:57

Let's, for a moment now, Thomas, consider factors which may dampen enthusiasm for small caps besides the interest rate and inflation issue. We're talking about heightened geopolitical risks. Are are they a greater concern for small caps or large caps?

Thomas Wash: 07:14

Well, small cap companies tend to focus on the domestic market, which we see as a strong positive because they are less likely to be affected by ongoing regional conflicts compared to large corporation. Think about it this way. Companies in the S and P 500, especially tech firms, derive much of their revenue from abroad. In fact, their foreign revenue exposure is about double that of smaller companies in the S and P 600. More troublesome is that many of these larger companies have a lot riding on China specifically.

Thomas Wash: 07:46

So if something happens in China, such as a war over Taiwan, a renewed trade war, or a regulatory crackdown, these companies are more likely to suffer some form of collateral damage.

Phil Adler: 07:59

You mentioned in your written report the growing popularity of certain passive funds. How does this factor into the equation for small caps?

Thomas Wash: 08:09

Absolutely. A key concern is how investment flows are impacting the market. The surge in ETF popularity has unintentionally favored larger established companies, and this is already influencing stock performance in 2024 with momentum being the leading driver of year to date returns. The attractiveness of passive funds lies in their ability to draw in more retail investors who can buy broad based funds so they do not have to rely on actual stock picking. As a result, large companies have been able to attract funds despite their seemingly rich valuations.

Phil Adler: 08:45

And how does private equity fund activity impact the small cap category?

Thomas Wash: 08:51

You see, a big concern of ours is that private equity funds are snapping up the most promising small cap companies. This could prevent the overall index from reflecting the true potential of the sector as the best performers might be getting acquired or delisted. The impact this has on survivorship could lead investors with a pool of less attractive small cap stocks for public purchase, potentially weighing on the index's overall

Phil Adler: 09:17

performance. Thomas, as we move toward our conclusion, in the Q2, Confluence Asset Management did downgrade exposure to small caps within conservative portfolios. Now is the firm ready to reverse this?

Thomas Wash: 09:31

Currently, we're discussing the impact of various factors on small cap stocks. While we believe they might outperform in a soft landing scenario, we also recognize the importance of considering other influences. These include, as you mentioned, the rising popularity of ETFs and private equity acquiring the most promising small companies.

Phil Adler: 09:50

And for investors who want to identify perhaps appealing sectors within the small cap category, what do you recommend?

Thomas Wash: 09:59

Focusing on high quality small cap companies that demonstrate robust sales growth and possess a competitive edge among their peers can be a winning strategy. Investing in such companies can potentially enhance your portfolio given their ability to sustain growth over the longer term.

Phil Adler: 10:15

Thank you, Thomas. Our discussion today is based upon sources and data believed to be accurate and reliable. Opinions and forward looking statements expressed are subject to change without notice. Also, this information does not constitute a solicitation or an offer to buy or sell any security. Our audio engineer is Dane Stoll.

Phil Adler: 10:33

I'm Phil Adler.