Are small caps cooked?

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Key takeaways

• Small-cap stocks have underperformed large-caps due to structurally less supportive long-term market dynamics
• In our view, we prefer not to own small-caps strategically over the long-term but rather take a more dynamic approach to the asset class as opportunities arise

Small-cap stocks have been viewed as persistent buy-and-hold winners since the ‘90s because their higher risk-premium led to historical outperformance.¹

But we think this return anomaly has faded.

When the small-cap anomaly started to gain notoriety, large firms had relatively more debt and made more acquisitions that weren’t always accretive to earnings. These bloated conglomerates often made small and nimble firms appear attractive.

But we’re now in a different era.

Small-cap stocks have lost much of their edge over the past decade, with persistent underperformance against large-caps driven by, what we believe to be, structurally less supportive long-term market dynamics rather than just short-term cyclical factors.

Share of unprofitable stocks in the Russell 2000 vs S&P500

But just because small-caps lost some of their edge doesn’t mean that we shouldn’t ever consider investing. We see reasons to own small-caps selectively with a more dynamic approach, trading on tailwind indicators rather than owning long-term.

If the Initial Public Offering (IPO) market re-emerges from its current winter, we believe that smaller firms could go public sooner and potentially allow the stock market to capture more early growth. In our view, small caps could also see tailwinds from rate cuts, which could lower the cost of their relatively high debt burden. If we see the Fed move faster than markets anticipate on the way back down, we believe those moves could provide an upside for debt-laden firms. Temporary supply disruptions have also benefited smaller stocks in the past.² Because large-caps tend to disproportionately rely on global supply chains, supply shocks and trade disruptions have served as a boon for firms that source domestically. These forces could create tradable events and sector trends.

It’s not that small-caps have lost all their potential; our analysis indicates that they *can* be great investments *when* bought at the right time.

So, for now, small-caps are on our watch-list as a periodic allocation.