No, we\u2019re optimistic about this diverse collection of companies, and we think investors without dedicated allocations should establish toe-hold positions in developed markets (DM) small-cap equities funded from DM mid- to large-cap peers. To be sure, these companies are more sensitive to changes in economic activity and credit availability than larger firms, meaning equity prices should be expected to be more volatile. But, we believe the better-priced small-cap equities will outperform over a three- to five-year time horizon, as we eventually overcome the current challenging environment.<\/p>\n
Our interest in small-cap equities is linked to its recent underperformance. As of close yesterday, DM small-cap equities returned -10.1% year-to-date, trailing DM mid- to large-cap stocks by 9.2 percentage points, according to MSCI indexes in local currency terms. Looking further back, the trailing three-year performance differential between these same two indexes is among the widest it has been in the 16 years for which we have data. This reality has had a clear impact on valuations \u2014one small-cap valuation metric we watch closely is trading at a near record deficit relative to larger stocks.<\/span> 1<\/a><\/sup> <\/p>\n But small-cap equities are vulnerable to financial stress. Their customer bases and suppliers tend to be less diverse than those of larger firms, which heightens these companies\u2019 idiosyncratic risks. Furthermore, while most small companies carry levels of debt relative to EBITDA that are similar to larger firms, small companies are more dependent on short-term funding markets, which can dry up in a crisis.<\/span> 2<\/a><\/sup> To date, central banks have been successful in keeping these markets functioning. Smaller companies also tend to have less of a cushion in case of a fall. In the last 12-month period, only 76% of DM small-cap stocks were profitable, as compared to 90% of the DM mid- to large-cap universe.<\/p>\n Thankfully, economic data has both improved and generally beat expectations, according to the Citigroup Economic Surprise Index. Also, high-frequency mobility data suggest the trend may continue. For instance, foot traffic at retail stores and entertainment venues are down just 4% in Germany, 12% in Japan, and 15% in the Unites States so far in July from pre-virus baselines of activity, all of which are slight improvements over June data.<\/span> 3<\/a><\/sup> While some jurisdictions will be forced to implement restrictions on activity again \u2014as California and other areas did so recently \u2014they may be more targeted than earlier this year.<\/p>\n Historically, small-cap equities have tended to outperform following a crisis. Of the eleven\u00a0US bear markets since 1960, US small caps outperformed US large caps across the subsequent three-year recovery period in nine of them, according to Fama-French data. The level of outperformance across those periods was material, with US small caps returning 24.3% per annum on average relative to 17.8% for US large caps. This return pattern conforms with what we know about investors\u2019 behavioral biases. Specifically, risky assets receive greater selling pressure in a crisis due to loss aversion than less risky assets, which can position those assets for greater rebounds.<\/p>\n Of course, much depends on COVID-19 timelines and the policies governments employ in response. Although yesterday\u2019s positive news about early stage clinical trials of a vaccine being developed by AstraZeneca and the University of Oxford are a clear reason to be hopeful, the performance of this position is likely to be uneven in the short term, fluctuating with the latest virus developments. Partly as a result, we recommend only establishing a toe-hold position in DM small-cap equities. As we gain greater clarity on the virus or as small caps develop momentum, we would consider whether a larger position size is warranted.<\/p>\nFootnotes<\/h2>