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Should Investors Continue to Overweight US Small Caps Despite Recent Banking Sector Stress and Growing Recession Fears?

Sean Duffin, Wade O’Brien

Yes, investors should overweight US small-cap stocks, given valuations remain attractive and will provide a cushion if an expected recession unfolds. Banking sector turmoil and the sensitivity of more leveraged companies to higher interest rates have weighed on sentiment, but corporate fundamentals and balance sheets are starting at healthy levels. Investors fleeing to the presumed safe-haven status of large-cap stocks, and mega-cap tech stocks in particular, may be overlooking stretched valuations that could call into question their performance during the next downturn.

The S&P 600 Small Cap Index is roughly flat and has underperformed the S&P 500 Index by around 1,000 basis points (bps) year-to-date. Larger weightings for the financials and real estate sectors have hurt performance, subtracting around 400 bps of total return since December. Recent months have seen three of the four largest bank failures in US history, while concern has existed for some time over what post-pandemic norms will mean for commercial real estate sectors like office.

Small-cap companies are also viewed as more vulnerable to a worsening credit crunch. The Federal Reserve’s Senior Loan Officer Opinion Survey shows banks are curbing lending and the cost of credit is rising. Small caps are more leveraged and thus more vulnerable than large caps. The 2.7x net debt-to-EBITDA ratio for the S&P 600 is well above its historical median of 1.7x and the comparable ratio for the S&P 500 (1.5x). If inflation remains uncomfortably high and the Fed’s target level remains higher for longer, interest rate expenses will continue to rise and hurt margins. The more reassuring news is that current interest coverage ratios (EBITDA/interest expense) for small-cap companies (around 6x) are close to their historical median and offer significant cushion for this likely scenario.

Valuations reflect these perceived headwinds. While historically small caps have traded at a slight premium to large-cap equivalents, today they trade at roughly a 30%–35% discount, using both short-term and normalized valuations. The decline in bank valuations does play a role, as recent bank failures are likely to mean rising deposit and regulatory costs. Small-cap REITs have also underperformed, even though many of these portfolios include assets in sectors such as industrial and “open air” retail, where fundamentals fared reasonably well during the pandemic. Still, our favorable view of small-cap valuations is not driven by just these two sub-sectors; the majority of small-cap sectors trade at a sizable discount to large-cap equivalents.

Historical data suggest small-cap companies tend to underperform large-cap peers when economic activity contracts, but there are reasons to believe that past might not be prologue this cycle. Small-cap companies already trade squarely in the range of valuations typically seen during recessions, while large caps are trading well above these levels. While 2023 earnings forecasts for small caps have been cut, they are expected to make a strong recovery in 2024. Investors risk missing a substantial recovery in small-cap stocks when economic conditions improve.

Small-cap stocks may benefit from longer-term catalysts, including US government initiatives such as the Infrastructure Act, CHIPs Act, and Inflation Reduction Act. These initiatives may provide more incentives for reshoring of supply chains, which is a trend that already appears to be well underway in the United States. Kearney research indicates that as many as 96% of CEOs have at least considered reshoring some or all manufacturing operations to the United States—a marked increase from last year. The majority have already committed to reshoring in the next three years. These shifts could benefit sectors that are overweight in small-cap stock indexes, particularly industrials and materials.

We expect that investors who maintain an overweight to US small-cap stocks will be rewarded. For investors that do not have existing exposures, rock-bottom valuations mean now may be as good an entry point as ever. While economic data are widely expected to deteriorate in the months ahead, some of this is reflected in current prices. Further additional banking sector stress is certainly a risk, but some of the recent challenges (large uninsured deposit ratios, asset/liability mismatches, etc.) were more idiosyncratic to specific banks than systemic. When growth and fundamentals eventually rebound, small-cap stocks could mount a substantial recovery.

Wade O’Brien, Managing Director, Capital Markets Research

Sean Duffin, Senior Investment Director, Capital Markets Research