Reflections

Small cap stocks (as measured by the Russell 2000 Index) returned 22% in the final two months of 2023, nearly twice as much as the 12% return for large cap stocks (S&P 500 Index).  This was notable as small cap stocks have underperformed large cap stocks over the past several years.  Could the recent small cap outperformance indicate a longer-term shift in the cycle?

We believe there are several reasons small cap stocks may have stronger relative performance to larger stocks in the years ahead.  First, valuations among small cap stocks are near the largest discount to large cap stocks in history.  This means that investors can purchase small cap companies at levels that are far less expensive than their large cap cousins.  Valuations alone may not be a reason to spark a rally among smaller stocks, but historically the starting price of an investment greatly impacts the degree of a rally once it begins.

Identifying a catalyst is difficult, but the list of potential triggers is long today.  First, sentiment toward smaller companies is incredibly low, so even a small improvement in investor demand would push shares higher.  Consider this: Apple has a market capitalization of $3 trillion.  This is more than the entire Russell 2000 universe of 2,000 small cap stocks combined.  If investors took even 1% of Apple shares and re-invested in small cap companies, the impact on demand would be noticeable.

Other catalysts include the moderation of inflation, pause in interest rates by the Fed, a stronger economy and smaller companies reporting stronger earnings growth.  The slowing of inflation and pausing of rate hikes was confirmed at the end of 2023, contributing to the small company rally to end the year.  Stronger earnings growth is also possible in the coming years, and in our view, the long-term potential for smaller companies is very promising.

According to 9/30/23 report by The Royce Funds, a study of history also reveals great possible optimism for future small cap performance.  Small caps by their nature experience boom and bust periods.  They have a well-established pattern where periods of low performance are followed by those with above average returns.  According to the Center for Research in Security Prices (CRSP), there have been 130 five-year periods in the past 78 years when small stocks (CRSP 6-10) produced less than a 5% annualized return.  We are currently in one of these periods.  In the past, the subsequent five-year annualized return for the previous 129 periods was a very impressive average return of 20% annualized.  That translates as an average 20% per year return, each year, for five years.  This is noticeably better than the overall 12.6% average for all five-year periods since 1946.  Also noteworthy is that small cap returns were positive 100% of the time following periods when they had averaged less than 5%.  While past performance is no indication of future results, we cannot help but be optimistic about the next five years for small-cap performance.

Small Cap Five Year Cycles

Subsequent Average Annualized Five-Year Performance for the CRSP 6-10 Following 5-Year Return Ranges of Less Than 5%