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Why Small Caps Now

The small-cap universe could prove ripe for investors looking for mispriced stocks.

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Two economists are walking down the street and find a $100 bill lying on the ground. A little while later, one of them turns to the other and asks, “Was that a $100 bill on the ground?” To which the other one replies, “Nope, if it was someone would have picked it up by now.”

While the joke pokes fun at the efficient-market theory in economics, the same could also be said about the current state of U.S. small caps. The Russell 2000 Index represents thousands of small companies—many of which have limited sell-side research analyst coverage. The small-cap universe could prove ripe for investors looking for mispriced stocks, but for many years opportunities in the small-cap universe have largely been ignored.

The last decade has been a story of large-cap outperformance. Since June 2003, the Russell 3000 Index has grown four-fold, largely on the strength of the large-cap companies in the Russell 1000 Index. As the chart below illustrates, the market capitalization of the next 2,000 companies in the index has fallen from a high of 9.5% to a 20-year low of 5.5% in the spring of 2023.

Small-Cap Exposure in Russell 3000 Index Lowest in Past 20 Years
Source: FactSet Monthly Russell Index Data June 2003 – June 2023.

You can make the argument that large-cap stocks are expensive or that U.S. small caps are cheap. We will focus on the latter. Starting at a low in valuations and weaving in multiple tailwinds that could support small-cap performance in the years ahead, we believe now may be the time for investors to take a second look.

Small caps: Priced Low Compared to Mid and Large Caps

U.S. small caps are cheap. If we look at a time period greater than many folks have been in the investment industry (1985–2023), small caps as represented by the Russell 2000 Index currently trade at a discount to mid caps (Russell Mid Cap Index) and large caps (Russell 1000 Index) across six different valuations metrics, including earnings, book value, growth, and free cash flow.

Small Caps Have Been Historically Inexpensive
Source: BofA US Equity & Quant Strategy, FactSet.

If we dial in on just earnings, small caps trade near their lowest price-to-earnings ratio (P/E) in over 30 years. This is in-line with the lows seen during the Global Financial Crisis (GFC) in 2008-2009 and below the lows from the 2001 recession and the COVID-related recession in 2020.

Price/Earnings (Past 12 Months) of Russell 2000 Index
Source: Russell 2000 Index.

We stress the importance of low valuations, as we believe it lays the groundwork for future performance. Since the inception of the Russell 2000 Index in 1984, the rolling 5-year average return is 10.4% while the current 5-year trailing return is 4.2%. That is important because our research suggests that below-average 5-year return periods historically for the Russell 2000 Index have been followed by a subsequent 5-year average return of 14.9% in 81 out of 81 periods examined.

If we look all the way back to 1925, U.S. small caps have outperformed their large-cap peers when analyzing cumulative returns.1 What is interesting about the market cycle since the Great Financial Crisis is that large caps have outperformed small caps by 300 basis points on an annualized basis.2 At nearly 14 years, this outperformance cycle by large caps over small caps is well past the historical average of 8-10 years. If history is our guide, cycles start and stop based on valuations. Given the stark contrast in valuations today and the long-in-the-tooth nature of this period, it appears markets have the potential to mean revert.

While some may view this analysis as justification to tactically overweight or underweight exposure based on what is happening in the macro environment, we also want to highlight the opportunity cost. The time and energy it takes to research investment managers and change an allocation can be immense. Looking at the average one-year forward return of the Russell 2000 Index following a market bottom, participation in all trading days resulted in a total return of 63.8%. If the first five trading days are missed, that return declines to 51.8%. If the first 30 trading days are missed, the average return was nearly cut in half to 37.2%.

The Winds of Change

Forecasting when an event may happen is a challenge, but it’s worth touching on potential tailwinds that could support investor interest in U.S. small caps. These tailwinds are noteworthy as they may not seem like tailwinds on their face and have largely been absent from the U.S. since the Great Financial Crisis: inflation, recession, capital spending (capex) and reshoring.

In 2022, the U.S. Consumer Price Index (CPI) registered its highest readings since the early 1980s. Cresting at a high of 9.1% in June 2022, CPI has mostly drifted lower, registering at 4.1% in September 2023, as the Federal Reserve’s prescription of a sharply higher fed funds rate, along with decreasing monetary and fiscal stimulus and an improving supply chain, took the steam out of price pressures.

What is interesting about the current moment is that historically, high and falling inflation has delivered a 21.3% average return for U.S. small caps over a sample period of 72 years (1950-2022).

Small-Cap Performance Over 72 Years
Source: Furey Research Partners. Time period reflects oldest dataset available from Furey Research Partners.

This dynamic has also played out when comparing small caps to their large-cap peers. Historically, in this market environment, small caps have generated an excess return of 5.2% compared to large caps.3 While no one can foresee with certainty the future path of interest rates, we believe this is something to consider as the battle against inflation wages on.

Moving on to the next tailwind, the term “recession” does not sound great for equity returns, but there is some nuance. In the event the fight against inflation tips the economy into recession, we believe small caps may be able to weather the storm better than their large cap peers. Away from starting at a lower valuation, earnings for companies in the Russell 2000 are largely geared toward services. While the S&P 500 Index has a roughly even split of earnings between services and goods (52% and 48%, respectively), earnings for the Russell 2000 are 66% from services and 34% from goods. We believe this is important because, historically, goods spending is two to three times slower to recover compared to services spending, based on prior recessions (the brief COIVD recession is an outlier). In light of the pent-up demand following widespread lockdowns, we believe that the post-COVID services recovery will remain strong, despite weaker demand for goods.

Spending on Goods vs. Services During Recessions

The last two tailwinds involve slow moving but potentially powerful changes in the global economy. In the aftermath of the COVID pandemic, many companies are looking at reshoring manufacturing in the U.S. due to supply-chain disruptions, trade tensions and geopolitical conflict. According to Bank of America Global Research,4 the number of mentions of “reshoring” on earnings calls went parabolic between 2019 and 2022, from a baseline of just above zero to nearly 100 mentions last year.

In theory, an increase in reshoring will require significant investments in the U.S. The need for more warehousing, small business banking, improvements to aging infrastructure, and energy transition investments are just a few of the areas in focus. Much of the money coming in the form of the CHIPS Act, Inflation Reduction Act (IRA), and the Infrastructure and Jobs Act (IIJA) required to support the shift toward reshoring bodes well for U.S. small caps as they tend to be correlated with capital expenditures. This is another area where the positive benefits accrue more to small caps versus their large-cap peers, as the correlation of U.S. capex growth and sales growth is stronger for the Russell 2000 than the  S&P 500.

Is it Time to Pick $100 Bills Off the Ground?

We believe cheap valuations and the potential for better days ahead make small caps attractive. No one knows what the future holds, but we believe these factors can help investments meet their financial objectives. While investing can be a challenging and complex pursuit, sometimes the best opportunities are those lying at your feet.

Footnotes  

1 Source: Ibbotson. Small Stocks—represented by the Ibbotson® Small Company Stock Index; Large Stocks—Ibbotson® Large Company Stock Index; Long-Term Government Bonds—20-year U.S. Government Bond; Treasury Bills—30-day U.S. Treasury Bill; Inflation—Consumer Price Index.
2 Source: eVestment. Based on Russell 2000 and Russell 1000 indices from 1979-June 2023; source for historical returns prior to 1979: Ibbotson SBBI US Small Cap Stocks vs. Ibbotson SBBI US Large Cap Stocks. Cycles defined by peak to trough inflection points in 10-year rolling excess returns. Length in years are rounded to nearest whole number.
3 Source: Furey Research Partners. Time period reflects oldest dataset available from Furey Research Partners.
4 Source: Bank of America Global Research. The Case for Reshoring


Definitions

Book value is a company’s total assets minus its total liabilities.

The Consumer Price Index (CPI) measures the overall change in consumer prices based on a representative basket of goods and services over time.

Efficient market theory or hypothesis argues that current stock prices reflect all existing available information, making them fairly valued as they are presently.

The fed funds rate is the interest rate that banks charge each other to borrow or lend excess reserves overnight.

Free cash flow represents the cash that a company generates after accounting for cash outflows to support operations and maintain its capital assets.

The Global Financial Crisis (GFC) refers to the period of extreme stress in global financial markets and banking systems between mid-2007 and early 2009.

Large caps or large-cap stocks refer to companies with a market capitalization value of more than $10 billion.

Market capitalization refers to the total dollar market value of a company’s outstanding shares of stock.

Mid caps or mid-cap stocks are terms given to companies with a market capitalization (or value) between $2 billion and $10 billion.

Opportunity cost is the forgone benefit that would have been derived from an option not chosen.

Price-to-earnings (P/E) ratio measures a company’s market price compared to its earnings.

The Russell 1000 Index, a subset of the Russell 3000 Index, represents the 1000 top companies by market capitalization in the United States.

The Russell 2000 Index measures the performance of the 2,000 smaller companies that are included in the Russell 3000 Index.

The Russell 3000 Index measures the performance of the largest 3,000 U.S. companies representing approximately 96% of the investable U.S. equity market.

The Russell Midcap Index is a market capitalization-weighted index comprised of 800 publicly traded U.S. companies with market caps of between $2 and $10 billion.

The S&P 500 Index is a stock market index tracking the performance of 500 large companies listed on stock exchanges in the United States.

Sell-side research is done by an analyst who follows a list of companies, all typically in the same industry, and provides regular research reports to the firm’s clients.

Small caps or small-cap stocks are public companies whose total market value, or market capitalization, is about $300 million to $2 billion.

Tailwinds are factors and events that help increase growth or cause positive effects on profits and revenue. Valuation is a quantitative process of determining the fair value of an asset, investment, or firm.

Any performance data quoted represent past performance, which does not guarantee future results. Index performance is not indicative of any fund's performance. Indexes are unmanaged and it is not possible to invest directly in an index. For current standardized performance of the funds, please visit www.AristotleFunds.com.

The views expressed are as of the publication date and are presented for informational purposes only. These views should not be considered as investment advice, an endorsement of any security, mutual fund, sector or index, or to predict performance of any investment or market. Any forward-looking statements are not guaranteed. All material is compiled from sources believed to be reliable, but accuracy cannot be guaranteed. The opinions expressed herein are subject to change without notice as market and other conditions warrant.

Investors should consider a fund's investment goal, risks, charges, and expenses carefully before investing. The prospectuses contain this and other information about the funds and can be obtained by visiting AristotleFunds.com. The prospectuses and/or summary prospectuses should be read carefully before investing.

Investing involves risk. Principal loss is possible.

Foreside Financial Services, LLC, distributor.

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