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<\/a><\/p>\nRecent small-cap underperformance was likely connected to the perception that they are more vulnerable to recessions and to concerns about their lower index weights for technology (and tech-like) companies, which were expected to benefit from COVID-related increases in demand. Still, while this may have been the expectation, small-cap earnings growth has turned out to be much stronger. In fact, S&P 600 earnings growth over the past five years was nearly twice that of global large-cap stocks (Figure 2). Put another way, despite the expected boost to revenue for companies in areas like hardware, software, and broadband from pandemic-related shifts in demand (e.g., e-commerce, work from home), it turned out smaller companies gained ground, given robust economic growth and a swift rebound in employment.<\/p>\n
The result is that small-cap valuations now look attractive both from an absolute and relative perspective. Using our preferred normalized price-earnings ratio (P\/E), which uses cash earnings, the current 51% premium for large caps has only been this rich around 9% of the time (Figure 3). Focusing on short-term valuations, the current forward P\/E of around 12.5 times for small caps is at an all-time low (based on data since 2005), starkly contrasting with the 17.9 times (81st percentile) for large caps.<\/p>\n The bar for making tactical decisions is high in the current environment of elevated geopolitical uncertainty, rising interest rates, and slowing economic growth. Equity investors should assess what these conditions mean not just for company fundamentals but also the equity styles favored by markets. There are different ways of answering this question, including looking at how small caps have performed historically across similar economic environments, the current health of small-cap balance sheets and operating models, and how the sector mix may (or may not) benefit small-cap investors.<\/p>\n While no two economic environments are exactly the same, small caps have historically fared relatively well during periods of elevated inflation. Looking at recession risk, the track record is spottier with, for example, small caps faring similar to large caps during the global financial crisis (GFC) but underperforming during the (extremely short) economic downturn in first quarter 2020. Still, valuations come into play, and we\u2019d note that during the GFC small caps traded at a premium to large caps, whereas today they trade at a steep discount. Overall, our confidence in relative prospects for small caps is more firmly rooted in this type of valuation analysis and prospects for specific sectors than an analysis of previous historical economic environments, especially as periods of elevated inflation have been limited in recent decades.<\/p>\n In a similar vein, while historically small caps have not fared as well during periods of Federal Reserve tightening as large-cap peers, we are less sure that past is prologue for several reasons. One is the historically large valuation differential mentioned earlier. Another is that the S&P 600 (our preferred US small-cap index) by design has a quality bias and fewer unprofitable firms than other small-cap indexes (Figure 4), making it less vulnerable to higher discount rates than certain peers. (The S&P 600 only adds companies that have reported a positive earnings result for both the last quarter and the sum of the trailing four quarters.) Finally, small-cap company leverage levels have come down and interest coverage levels are elevated, making them less vulnerable to the expected rise in interest costs.<\/span> 1<\/a><\/sup> Russell 2000\u00ae Index interest coverage stands at 5.3 times, well above levels seen during the depths of COVID-19 and the highest since 2014. (Please see Elias Krauklis and Venu Krishna, “Small Caps Keep Sliding,” Barclays Equity Research, May 6, 2022.)<\/p>\n<\/a><\/p>\n<\/a><\/p>\nLooking Ahead: Prospects for the Macro Environment<\/h3>\n