Are US Small Caps Poised to Outperform?

Yes. We believe higher-quality US small-cap companies trade at a significant discount to large-cap peers, and their balance sheets have held up better than headlines suggest. Recent earnings for small-cap companies have disappointed, but we see this as more driven by sector and cyclical effects that should ease over the next 12 to 18 months than higher interest expenses. As earnings start to rebound, we expect the market to shift its focus back to the compelling valuation discount offered by US small caps, setting the stage for the next leg of their outperformance.

Many financial publications have recently argued that US small-cap stocks will struggle until the Federal Reserve starts easing. They typically noted that 1) small-cap companies are more levered than large caps, 2) small-cap companies have more floating rate debt and thus suffer more from Fed tightening, and 3) many small-cap companies are unprofitable, further compounding these issues.

This narrative has some element of truth to it, especially when discussed in the context of the Russell 2000® Index. Around 40% of Russell 2000® companies don’t have positive earnings, are more levered than large-cap equivalents, and around half of their debt is floating rate.

However, these arguments are less applicable to quality small-cap companies, which can be proxied with the S&P SmallCap 600® Index. Around 80% of S&P 600 companies were profitable in 2023, compared to around 60% for the Russell 2000® Index. S&P 600 companies do have more leverage than large-cap peers, but neither absolute levels of debt nor recent trends are concerning. The median S&P 600 (non-financial) company had debt-to-EBITDA of 2.4x at the end of 2023, basically unchanged from 2019 (pre-pandemic) levels. Furthermore, despite suggestions that Fed hikes are increasing interest expenses and weakening debt servicing ability, the median interest coverage ratio for an S&P 600 (non-financial) company, 7.5x, remains similar to 2019 levels. For context, this is well above the typical coverage level of a high-yield borrower of around 5x. The “tails” or weakest links have also held up. The interest coverage ratio of the lowest decile (10th percentile) S&P 600 borrower was 2.6x at the end of 2023, down slightly from the year before but almost identical to 2019 levels.

The simple explanation for this is that growth in cash flow of US small-cap companies has outpaced that of their interest expense, as these companies have benefited from strong domestic economic growth in the United States in recent years (roughly 90% of small-cap revenue is domestic). There is also a more subtle dynamic that reduces the macro threat of higher rates to small-cap investors. A significant portion of the leverage in the small-cap index is concentrated, with about 50% of the total debt of the S&P 600 held by around 10% of the companies. In most cases, these firms also have the cash flow to service their debt.

While leverage fears have been overstated, earnings growth has, indeed, been weak. S&P SmallCap 600® Index earnings dropped around 30% in 2023 and are only expected to rebound around 8% in 2024. Sectors like healthcare and retailers are struggling with margin pressures, given tight labor markets, and a high index weight for the struggling REIT industry does not help either. That said, there are some nuances the market may be overlooking. One is that the earnings drop in 2023 was from a very high level—in fact, index earnings more than doubled between 2019 and 2022. Another is that as contracts for some companies are being reset and margins restored, expectations for 2025 look encouraging. The S&P SmallCap 600® Index is expected to grow earnings almost 20%.

Persistent inflationary pressures mean expected Fed rate cuts have been pushed back by the market, and the perception that lower rates are required for small caps to outperform could continue to hang over the asset class. In the meantime, the 14x forward price-earnings ratio for small caps reflects a historically wide 30% discount to large caps and is not justified by balance sheets or operating fundamentals. As the market eventually shifts its focus to long-term earnings potential, small caps are poised to shine.

Wade O’Brien, Managing Director, Capital Markets Research