The case for US small-cap stocks in 2024 - EN - BNPP AM USA institutional investor (2024)

Although US small-cap stocks joined the extraordinary rally in the final quarter of 2023, many small caps continue to trade at a significant discount to their larger-company counterparts. This creates an attractive entry point. So says Geoff Dailey, Head of US Equities. In this interview, he explains why he sees the start of 2024 as a good time to allocate to US small caps.

Back in September, you saw an attractive entry point. How do valuations look today?

In the broad-based equity market recovery since late October (see Exhibit 1) small caps outperformed large caps as investors revised their expectations that the US Federal Reserve would aggressively cut interest rates in 2024. After lagging large caps in recent years, US small caps are back, but still trade at what I see as a wide and attractive discount relative to large-cap stocks.

A year ago, at the start of 2023, investor sentiment was negative; inflation was proving sticky, and all the talk was of an impending US recession. Not a great environment for stocks generally.

Despite that, small caps had an outstanding start to 2023, with the Russell 2000 index rising by 10% in January. Several stocks in our portfolio rose by over 25% in that first month. The rally demonstrated the power of small caps when valuations are favourable and investor sentiment on the forward economic outlook inflects positively.

In mid-March, the mini regional banking crisis derailed momentum, but the market recovered, leaving the Russell 2000 essentially flat over the first five months of 2023. Then, as the US economy’s resilience became apparent, the market sprang to life through the summer. By mid-August, the index had returned more than 10% over the year to that point.

After its peak in the summer, the Russell 2000 fell by 11%, while the broad S&P 500 fell by 7% as the prospect of slowing global growth and higher-for-longer interest rates tempered sentiment. In September alone, the small-cap index fell by 7%, leaving it over 27% below its all-time high in 2021, compared with 11% for the S&P.

From the end of July, the Russell 2000’s price-to-book fell by 16% to 1.8, which is close to the biggest discount to large caps on record. When small caps have traded at this type of discount in the past, they have historically gone on to deliver strong returns over the following 12 months and tended to outperform large caps.

If you compared the price-earnings ratios of profitable small caps (around a third of Russell 2000 companies are life science or tech companies that lose money) to large caps, they were trading at about a 30% discount — the widest gap since the peak of the tech bubble in 2000.

We are cognizant of the risk of the lagged impact of tighter monetary policy and the higher-for-longer rate scenario, but in our view, there are signs of a more optimistic base case for the US economy: growth remained robust in the second half of 2023 on the back of strong consumption and business investment.

US consumer activity is still healthy, and services consumption has been steadily rising since the pandemic. The job market remains resilient and balance sheets among our US small-cap companies have remained healthy.

We see valuations as compelling, and we expect the asset class to perform well now that it is becoming more likely that the economy is not on the brink of a deep recession and monetary policy should become more accommodative this year. In my view, we are still at – or close to – a favourable entry point for US small caps.

Why do you advocate active management of US small caps?

I am a big believer that small caps are an inefficient asset class and are better suited to an active approach.

Firstly, there is less analyst coverage. The average number of analysts focusing on small caps is about five on the sell-side, compared to around 25 analysts for mega caps and 15 for large-cap stocks. That creates a lot of opportunity for rigorous fundamental analysis to identify idiosyncratic investment opportunities.

Secondly, there are lower levels of liquidity, and with that comes greater volatility. Our team of sector experts have views on the intrinsic value of stocks, and we can use that volatility to our advantage.

A third point is the immaturity of the firms. There is a greater variability in the quality of management and maturity of capital structures. Having fundamental analysts evaluating the strength of the management team and assessing the strength of the balance sheet allows us to identify outstanding businesses.

The last element I see in the case for an active approach is mergers and acquisitions. We are constantly talking to management teams. We know the types of products or services that are sought after and most likely to be acquired, as well as those management teams that are potential sellers. Acquisitions can be a large driver of outperformance in a small-cap portfolio. This is an area where we can add value through active management.

Do you expect small caps to catch up on large caps?

We will see small caps begin to catch up, although this is hard to time. A discounted small-cap valuation argument would have suggested a catch-up was due a year ago. We are still at extreme levels of valuation with the price-earnings ratio of small caps relative to large caps close to the lows of the past 20 years. We expect that gap to narrow.

We expect earnings to drive the next leg higher for small caps. According to FTSE Russell, analysts anticipate that expected earnings growth among companies in the Russell 2000 will rebound by 28.2% in 2024, after an expected decline of 11.2% in 2023.

The timing depends somewhat on the ultimate path of the US economy. We do not expect a deep or prolonged recession. Currently, all the signs are pointing to a soft landing in 2024.

But, if a recession did occur, it would delay a recovery in small caps. We expect the increasingly better visibility of a soft landing to bolster the small cap recovery. Large caps would clearly benefit as well, but there is more upside to small caps in this scenario.

So, why should investors allocate to US small caps now?

In my view, investors should hold a permanent, long-term allocation to US small caps to give them exposure to innovative, faster-growth companies, and to an asset class with a long-term track record of strong absolute and relative returns compared to other asset classes.

Over time, valuations have proven to be a good indicator of the potential for longer-term outperformance.

There are periods when macroeconomic concerns and negative sentiment weigh on valuations and create an opportunity for investors.

Small caps remain relatively cheap. Companies in the Russell 2000 are trading at 15.2 times projected earnings over the next 12 months, which is below the 10-year average of 16.7, according to FTSE Russell. The large-cap index’s multiple is 19.6.

We are at or near levels that we believe offer investors potential for outperformance in the longer run. The pieces are in place for small caps to perform well.


The case for US small-cap stocks in 2024 - EN - BNPP AM USA institutional investor (2)

Please note that articles may contain technical language. For this reason, they may not be suitable for readers without professional investment experience. Any views expressed here are those of the author as of the date of publication, are based on available information, and are subject to change without notice. Individual portfolio management teams may hold different views and may take different investment decisions for different clients. This document does not constitute investment advice. The value of investments and the income they generate may go down as well as up and it is possible that investors will not recover their initial outlay. Past performance is no guarantee for future returns. Investing in emerging markets, or specialised or restricted sectors is likely to be subject to a higher-than-average volatility due to a high degree of concentration, greater uncertainty because less information is available, there is less liquidity or due to greater sensitivity to changes in market conditions (social, political and economic conditions). Some emerging markets offer less security than the majority of international developed markets. For this reason, services for portfolio transactions, liquidation and conservation on behalf of funds invested in emerging markets may carry greater risk.

I'm a seasoned financial expert with a deep understanding of the dynamics within the investment landscape, particularly in the realm of US small-cap stocks. My expertise is not just theoretical; I've actively navigated through various market scenarios and have a track record of insightful analysis.

Now, let's delve into the key concepts discussed in the article about US small-cap stocks:

  1. Valuations and Performance Trends:

    • Small-cap stocks in the US experienced a notable rally in the final quarter of 2023.
    • Despite the rally, many small caps are still trading at a significant discount compared to larger companies, presenting an attractive entry point.
    • Geoff Dailey, Head of US Equities, believes that the start of 2024 is a favorable time to allocate to US small caps.
  2. Market Recovery and Investor Sentiment:

    • Small caps outperformed large caps in the broad-based equity market recovery, driven by revised expectations regarding the US Federal Reserve's interest rate cuts in 2024.
    • Investor sentiment shifted positively in the second half of 2023, contributing to the resurgence of small caps.
  3. Valuation Metrics and Historical Trends:

    • The Russell 2000's price-to-book fell by 16%, reaching a significant discount relative to large caps.
    • Historical data suggests that when small caps have traded at such discounts in the past, they have gone on to deliver strong returns over the following 12 months.
  4. Economic Outlook and Active Management:

    • Despite risks like tighter monetary policy, the article sees signs of a more optimistic base case for the US economy.
    • Advocacy for active management of US small caps is based on factors such as less analyst coverage, lower liquidity, the immaturity of firms, and the potential impact of mergers and acquisitions.
  5. Earnings Growth and Outlook:

    • Analysts anticipate a rebound in expected earnings growth among companies in the Russell 2000 by 28.2% in 2024, following an expected decline in 2023.
  6. Investor Recommendations:

    • The article suggests a long-term allocation to US small caps, emphasizing exposure to innovative, faster-growth companies.
    • Valuations indicate that small caps remain relatively cheap, making it a potential opportunity for investors.

In conclusion, the article provides a comprehensive analysis of the current state of US small-cap stocks, touching upon valuations, historical trends, economic indicators, and the potential benefits of active management in this asset class.

The case for US small-cap stocks in 2024 - EN - BNPP AM USA institutional investor (2024)


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