Is now the time to invest in small-cap stocks?

Low valuations, lagging performance and concerns over an AI-inflated large-cap bubble may soon spur interest in smaller companies

While US tech titans are flying, smaller company stocks remain unloved and overlooked. Getty

Any investor who believes in the old mantra “buy low, sell high” might be tempted to dump their overhyped, overbought US technology stocks right now and pour their profits into the out-of-favour smaller companies sector instead.

While US tech titans are flying on the back of this year’s artificial intelligence and machine learning craze, with chip maker Nvidia rocketing by 200 per cent so far this year, shares in smaller companies remain unloved and overlooked.

Last year was tough on the little guys, with the MSCI USA Small Cap Index crashing 17.17 per cent.

That was roughly in line with the S&P 500’s drop. But this year, the US index of large caps has rebounded 15.73 per cent, while US small caps have fallen by another 3.43 per cent.

In Europe, small caps suffered their worst year relative to larger companies since records began, according to fund manager Abrdn.

Small caps are trading at low valuations, so is it time to fill your boots? As ever with investing, it is not that simple.

Smaller companies are seen as more volatile than the big blue chips. They fly higher when the economy is booming and crash harder when trouble strikes.

Early stage companies pay fewer dividends as they focus on building their business rather than rewarding shareholders. They are also more likely to go bust. When investors are nervous, they look almost anywhere else.

Hopes that 2023 would herald a recovery have been dashed so far, as repeated interest rate increases drive up the cost of the capital that smaller companies need to grow, and make it harder to access as well.

Today belongs to large caps, yet a growing number of analysts believe that smaller companies are gearing up to enjoy a moment of their own.

It is undoubtedly true that smaller companies tend to underperform during economic downturns, as risk-averse investors typically favour mature, well-established larger companies, says Anjli Shah, investment director at Abrdn.

Yet, dig a little deeper and a surprising conclusion presents itself.

“The time to start allocating capital to small caps might be sooner than investors think,” she says.

Smaller companies historically start outperforming large caps soon after a recession starts, she says.

“That’s because the market tends to price in an economic recovery before it happens. Yet, this phenomenon is not part of the traditional small/large-cap narrative. We believe this disconnect creates opportunities for active investors.”

Rising inflation and interest rates are less of a threat than many imagine, Ms Shah says.

Many smaller companies operate in niche industries or areas of the market with few players. They may be a critical link in complex supply chains or wider manufacturing processes.

“As a result, they can dictate higher prices despite their size, allowing them to pass on costs to protect their margins. They also have the agility to change where they source goods and materials, further helping to control costs,” according to Ms Shah.

This year’s banking crisis may have had a disproportionate impact on small-cap performance, at least in the US, as the Russell 2000 Index of smaller US companies includes sizeable weightings in regional banks.

Low relative valuations, lagging performance, the passing of the banking crisis and concerns over an AI-inflated large-cap bubble may soon spur a small-cap revival, says Chuck Royce, chairman and portfolio manager at Royce Investment Partners.

“We think small cap is ready to roll and expect the next three to five years to be strong on both an absolute and relative basis,” he says.

Buying individual smaller company stocks is risky and researching them is time-consuming.

If tempted by small caps, most investors should stick to an actively managed or exchange-traded fund that spreads the risks across dozens or even hundreds of smaller companies.

There are loads of ETFs to choose from, including the iShares MSCI World Small Cap UCITS ETF, the Vanguard Russell 2000 Growth ETF and the Xtrackers MSCI Europe Small Cap UCITS ETF.

However, some analysts warn that small caps may have to wait a little longer for their moment to arrive.

Mathieu Racheter, head of equity strategy research at Julius Baer, notes that small caps have trailed large caps by about 7 per cent this year in US dollar terms and look relatively cheap. But he cautions: “While small caps appear attractively valued, the high share of non-profitable companies and greater exposure to floating debt make them vulnerable.”

About 25 per cent of global small caps currently have negative earnings. The average return on equity and profit margins is roughly half that of large caps.

Smaller, growing companies may struggle if interest rates stay higher for longer, as many now expect, as roughly a third of their outstanding debt has been issued at floating rates.

“This stands in stark contrast to the large-cap space, in which 94 per cent of the outstanding debt has been issued at fixed rates and with long duration,” Mr Racheter says.

Given the risks, he concludes that “we would refrain from adding exposure at this stage”.

Buying low and selling high may be every investor’s dream but it requires a double dose of courage.

Buying losers is not easy. Nor is selling winners. Especially when they are big winners such as technology.

Big Tech could continue to climb and comparisons between the surge in AI-related stocks and the ill-fated dot-com boom of the late 1990s have been overdone, Mr Racheter says.

“The current rally is, to a large extent, driven by fundamentals such as earnings, while the dot-com bubble was largely driven by euphoric multiple expansion.”

He thinks it will continue, which would make shunning US technology a losing bet (as it has been for years).

Investors have to be brave to buy smaller companies today but if they are patient, it could still pay off.

When interest rates peak, the recession passes and sentiment picks up, they will probably lead the charge, as they usually do.

As in any recovery, the big gains are made right at the beginning. Those who wait until after the recovery is secure will have missed out.

Buying large and small caps is not an either/or decision. Every portfolio should make space for both.

It is worth checking your portfolio to see how much exposure you have to these two sectors. If you have gone too large, it may be time to think small.