Is Now the Time for Small Cap — finally?
If you’re a financial pro, you know small caps are typically one of the first asset classes out of a recession. In fact, it is small caps are one of the “first in, first out” (FIFO).
Clearly, small cap has underperformed through 9/30 this year. Small cap has underperformed for the last 10 yrs (Russell 2000 vs. S & P.) And don’t forget that the Market discounts 6-12 months in advance.
But not all publicly traded companies with a market cap of $300 million to $2 billion (the traditional definition of small cap) are created equal.
In fact, as of January 31, 2022, the weighted average market capitalization for a company in the Russell 2000 index was around $3.1 billion; the median market cap was $1.0 billion, according to Wikipedia. This means approximately 8 percent of the Russell 2000 are actually mid cap companies.
In 1990 when William Sharpe and John Lintner won the Nobel Prize for their paper on asset pricing, small cap wasn’t even part of the Capital Asset Pricing Model (CAPM). But in 1992 Eugene Fama and Kenneth French saw to that, when they added size and value to the single factor of market risk premium.
More recently, the whole value of small cap has been challenged, at least until you separated out companies with strong fundamentals, like profits, from the rest of the small cap universe. Speculative small cap relies on momentum and “hope”, while real small cap investing relies on fundamentals and stable financial conditions (good balance sheet, no immediate need for capital, path to cash to cash flow positive). By the way, the former way of investing has been rewarded by the markets (i.e., meme stocks) for years. That’s changing.
For years, with the Fed tailwind, making distinctions didn’t matter. It’s always been important, but now more than ever. That’s the problem with most small cap indices-they don’t separate the universe in a meaningful way. Not to say there are not ETFs like DFAS that do. But we believe you are better off owning individual companies based on fundamental research.
But maybe it’s different this time. Could what’s playing out on the global stage have a lasting effect and change how asset allocation works? Things like…
- China – lockdowns and potential retaliation with Taiwan
- Europe – Ukraine War, energy dependence, EU disparities
- Emerging Markets – political considerations (ex. Brazil)
- Re-shoring happening globally–which we wrote about last week
- Globally dominant players face scrutiny (ex. regulatory) and risk (ex. political)
- Companies most impacted by rising USD facing major headwinds
- Currency risks — massive headwind for non-US borrowers denominated in USD, must hedge or have a view
All this is resulting in Investors staying close to home due to more complexity of non-US markets.
We believe we are seeing our 5 points of inflection lining up across every asset class. This is where entire industries can be massively disrupted, behaviors change, business models are reimagined, traditional investment cycles are outsized by new opportunities, and earlier adopters step in to scale new ideas.
One thing is clear, we appear to be at the beginning of a recession and the question is: Will small caps be one of the asset classes that are first in and first out?
We think they will.
And we also think our top-performing small cap strategy, which turns 3 years old in December, has the potential to be out front when they do.
Validus Growth Investors, LLC seeks to invest in companies at every stage of their growth. From startups to publicly traded companies, our research identifies inflection points that have the potential to produce meaningful growth and income for the clients we serve.
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