Author Details

Abhishek Gupta

Abhishek Gupta
Executive Director, MSCI Research

Ashish Lodh

Ashish Lodh
Vice President, MSCI Research

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Sizing Up Small Caps

  • Despite rallying since April 2020, small caps remain at lower valuations compared to mid- and large-cap companies and have received higher earnings-growth forecasts from analysts in the short term.
  • Small caps have on average historically outperformed large and mid-caps in “risk-on” market regimes (falling volatility and tightening credit spreads) and in rising-inflation/low-interest-rate environments.
  • Across 17 megatrends identified by MSCI, companies with significant theme relevance were found to be predominantly small caps. In addition, a large number of small-cap companies had strong quality exposures.

Since its lows in March 2020, the global market has ushered in a strong comeback in the performance of smaller-sized companies. This is not surprising as small companies have historically thrived in a stronger economic environment. In addition, low-size ETFs have seen increased inflows through May 2021.

Questions for many, however, include: Given small-cap stocks’ outperformance over the past 16 months, how do they compare with larger-cap stocks in terms of valuation, sentiment and macroeconomic conditions in the short term? And, in the long term, what opportunities might small caps offer? We found that small caps currently exhibit healthy fundamentals and technical strengths. Additionally, they have historically represented a large subset of the equity universe that corresponded to innovation and megatrends that are expected to shape the future of the global economy. Investor caution may be prudent, however, as the macro-regime shifts and/or megatrends reshape.

 

Small-Cap Fundamentals

The underperformance of small caps relative to large- and mid-cap stocks over the past decade resulted in a nearly secular decline in relative valuations of small caps in developed markets. Even though small caps saw a stronger rebound since March 2020, their valuations relative to larger size segments continue to be below the developed markets’ decadal average.

Additionally, analysts estimate higher earnings growth for small caps in the short term. The exhibit below shows that in July 2021, compared to a year ago, both short- and long-term earnings-per-share (EPS) growth forecasts improved across the board. As of July 2021, the long-term (3- to 5-year) forecast EPS growth in developed markets was comparable across smaller- and larger-cap stocks, though in emerging markets it was higher for small caps. Further, the short-term (12-month) estimate was much higher for small caps across both developed and emerging markets, although the forecasts also improved for large and mid-caps. This may be because a market recovery can potentially position smaller companies to grow earnings relatively quickly as their business models could be nimbler than some of their larger-cap counterparts.1

 

Small Caps’ Strong Relative Valuations and EPS Growth Forecasts

Left plot: Relative valuations calculated as the ratio of (book-to-price and forward earnings-to-price)/2 for small caps to large- and mid-cap stocks. Right plot: Analyst estimates corresponding to July 31, 2020, and July 30, 2021.

 

Investor Sentiment

Our research has shown that performance of small caps relative to large- and mid-cap stocks was responsive to market sentiment, as measured by Cboe Volatility Index® (VIX®) futures’ term structure and credit spreads. Historically, downward-sloping VIX futures curves and elevated credit spreads have coincided with crisis periods, giving an indication of “risk-off” regimes. Recently, both VIX (with near-term futures contracts lower than longer-term contracts) and credit spreads (which have tightened below their 12-month moving average) pointed to a risk-on market environment. Historically, small caps have outperformed large and mid-caps during such risk-on regimes in developed and emerging markets, though they have underperformed in risk-off regimes.2

We also looked at changes in analyst EPS forecasts. Over the past year, the proportion of small-cap stocks with improvement in forecasts sharply increased and the proportion of stocks with weakening EPS forecasts decreased, implying a strong positive turn.

 

Sentiment and Small Caps

Left plot: period from Dec. 31, 1998, to June 30, 2021. Right plot: period ending July 30, 2021. Sourced from MSCI FactorLab. Increase (or decrease) in EPS forecasts correspond to >1 (or <-1) standard deviations.

 

Small Caps in Different Macroeconomic States

We saw a sharp increase in inflation over the first half of 2021 with the consumer price index (CPI) reaching 4.1% in June 2021, doubling its 10-year average.3 Short-term rates in the U.S. (three-month U.S. Treasury rates) have, however, continued at the near-zero levels seen since April 2020.

Smaller companies have tended to be impacted differently by inflation and interest rates than larger ones. Historically, in low-rate regimes, the small-size factor has shown strong positive performance as the cost of capital remained low. Further, rising inflation has proven beneficial in such an environment, potentially resulting from small companies’ ability to transfer higher input costs to end consumers. However, when short-term interest rates were higher (more than 4%), small-size-factor performance has been negatively affected, in general, as levered small firms have struggled with financing their business operations.4

 

Rising Inflation and Low Interest Rates Have Benefited Small Caps

Period from Jan. 31, 1971, to June 30, 2021.

 

Small Caps May Widen Thematic Investing, Value and Quality Opportunity Sets

Thematic investing is intended to focus on key themes that may shape tomorrow’s global economic landscape. Across each of the 17 megatrend themes MSCI has identified, companies with significant theme relevance were found to be predominantly small caps.

 

Small Caps Big on Themes

Data as of February 2021. Securities are filtered from the MSCI ACWI IMI constituents, based on thematic relevance score greater than 0.25 to individual themes.

Additionally, in contrast to what some investors believe, small caps have provided an opportunity to capture value and quality premia. As seen in the exhibit below, the high-/low-value divide within the MSCI Small Cap Index universe was similar to that within the large-/mid-cap segment. Small caps had a slightly lower quality bias, but there were a large number of small-cap companies with strong quality exposures.

 

Quality- and Value-Score Distributions

MSCI FaCS exposures as of July 30, 2021.

Whether inflation proves transitory and how quickly the Federal Reserve moves to taper quantitative easing and, subsequently, hike rates may have implications for the global recovery and the broader market, including small caps. Recently, small-cap stocks have been comparable to other types of equity investments in terms of fundamentals, investor sentiment and analysts’ outlook. Beyond short-term market dynamics, small caps also have been relevant to active factor and thematic investors.

 

 

1“With tech giants dominating markets, does the 'size' factor still matter?” BlackRock, Oct. 20, 2020.

2The analysis is contemporaneous. Index returns and risk-on/risk-off signals on the same months (no look ahead) are used to report conditional returns. Past performance — whether actual, backtested or simulated — is no indication or guarantee of future performance. None of the information or analysis herein is intended to constitute investment advice or a recommendation to make (or refrain from making) any kind of investment decision or asset allocation and should not be relied on as such.

3CPI reported for OECD economies. The data on OECD CPI is obtained from the Organization for Economic Cooperation and Development (OECD) database.

4The small-size factor is the standard Fama-French size factor obtained from Kenneth French data library. The Fama-French size factor has been used as it has a deep history going back to the high-inflation periods of 1970s.

 

 

Further Reading

Hedging Inflation with Equities

Index Performance in Changing Economic Environments

Factors in Focus: Go with the Flow?

Adaptive Multi-Factor Allocation

What’s Driving Increased Interest in Small-Cap Performance?

Regulation