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Finding value in small caps

PUBLISHED

2023-11-29

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Investors are finding compelling opportunities in an unexpected corner: small-cap value shares.

As per a recent report from JP Morgan, small-cap value stocks are currently trading at a 14% discount compared to their 20-year average price/earnings multiples, while large-cap growth shares, led by the tech behemoths of the "Magnificent Seven," find themselves trading 36% above their historical averages.

The divergent performance between these two categories is quite stark, with the Russell 2000, representing smaller-cap companies, experiencing a bear market since its peak in late 2021. It has trailed behind the Russell 1000, which tracks larger-cap stocks, by a substantial margin of approximately 20 percentage points.

Several factors may account for the recent underperformance of small-cap shares, including the impact of rising interest rates. However, this phenomenon is not confined to the short term. Since 2015, the Russell 2000 has consistently lagged behind the S&P 500, even during periods of historically low interest rates. Such prolonged underperformance is unusual for small-cap stocks, which have historically outperformed or at least kept pace with larger-cap companies over extended time horizons. For instance, since 2000, the S&P 500 and the Russell 2000 have delivered almost identical returns. Moreover, historical data dating back to 1926, up to July 2023, reveals that small-cap value shares have generated an annualised return more than four percentage points higher than their larger-cap growth counterparts, as reported by The Wall Street Journal.

These historical trends suggest that the leadership of the stock market could soon shift from large-caps to small-caps, especially in the event of an economic slowdown. Over the past 11 recessions, small-cap stocks have outperformed their larger counterparts by an impressive margin of over 16% during the 12 months following the onset of a recession. A case in point is the period surrounding the dot-com crash. From 1995 to 2000, the S&P 500 outpaced the Russell 2000 by eight percentage points annually. However, in the subsequent years from 2001 to 2004, the S&P 500 experienced a decline of about 2%, while the Russell 2000 value index surged by a staggering 80%. Beyond attractive valuations, small-cap stocks also benefit from a robust dollar, tending to shine during periods of sustained dollar strength.

Nevertheless, it's essential for investors to exercise caution when considering small-cap investments, as they are not without their share of risks. Nearly 50% of the companies within the Russell 2000 index are unprofitable, and their earnings before interest and taxes cover a smaller percentage of their interest expenses compared to their larger-cap counterparts.

In this context, Boyar Research has identified three small-cap stocks with promising investment potential, as outlined in their recent Boyar Opportunity Reports. These stocks include a company chaired by the highly regarded hedge fund manager Bill Ackman, a firm poised to capitalise on the post-pandemic surge in enthusiasm for golf both on and off the course, and a leading manufacturer of kitchen cabinets.

As investors weigh their options in the dynamic stock market environment, small-cap value shares are emerging as an enticing proposition, offering a glimpse of potentially brighter days ahead for savvy investors willing to navigate the intricate terrain of stock valuation and market trends.

The picture is similar within the Australian landscape.

Over the past 24 months, Aussie small-cap stocks have underperformed when compared to their larger counterparts (see image below). This underperformance can be attributed to the challenges posed by high inflation and the accompanying rise in interest rates, which have exerted significant pressure on the performance of small-cap equities. Notably, the valuation gap between small-cap and large-cap stocks is currently nearing its highest level in almost a decade.

 

The chart above compares the S&P/ASX Small Ordinaries (INDEXASX:XSO) to the S&P/ASX 100 (INDEXASX:XTO). The S&P/ASX Small Ordinaries (XSO) represents the small-cap component of the Australian stock market, including all companies in the S&P/ASX 300, excluding those in the S&P/ASX 100.

The chart shows that the S&P/ASX Small Ordinaries performed roughly 20% worse than the S&P/ASX 100 over the last two years.

 
Source: ASX

The P/E ratio chart shows that small-cap stocks have experienced a decline in P/E ratios since 2021, but they are now at the average level seen in the seven years before the COVID-19 pandemic. This decrease in P/E ratios is primarily due to reduced after-tax profit margins in small-cap stocks over the past two years. As earnings rebound, the declining P/E ratios suggest that small-cap stocks may be undervalued.

Australia is currently witnessing a decrease in peak inflation and a stabilisation of interest rates, which creates a favourable environment for reversing the underperformance of undervalued small-cap stocks. Private equity fund managers and corporations have been increasing their acquisition activity of small-cap stocks, indicating their belief in the attractiveness of these stocks' prices and their confidence in buying them at this stage in the market cycle. Some bidding wars have even occurred, setting a valuation floor and bolstering investor confidence.

As the economy continues to improve, certain small-cap stocks may recover lost profit margins, and reduced uncertainty may attract investors seeking growth opportunities. This increased interest could enhance the liquidity of small-cap stocks, making them more appealing for investment.

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