Small-capitalization stocks have been overshadowed so completely by their larger cap cousins in recent years that a top market strategist and portfolio managers at Morningstar’s annual investment conference in Chicago last week refrained from offering a prediction as to exactly when the sector will return to favor.
However, at the session last Wednesday entitled “Why Bother with Small Caps in the World of the ‘Magnificent Seven?," three top fund managers on the panel did tell attending advisors, fund managers and investors they should consider small caps because the asset class is plump with investment opportunities both here and abroad. Industrials, regional banks and consumer discretionary are among the sectors investors should consider adding to their portfolios, said the fund managers, whose strategies range from value to growth and from small- to mid-cap.
The managers—Keith Lee, chief executive officer and senior portfolio manager at Brown Capital Management; Morgen Peck, portfolio manager at Fidelity Investments; and Don San Jose, chief investment officer of the U.S. Value Team at J.P. Morgan Asset Management—pushed back against the bearish narrative against small caps. Critics dismiss the asset class for, among other things, lacking a meaningful competitive advantage versus their larger cousins while suffering from weaker fundamental and too much debt.
“Small companies will do well again,” declared Lee, of Baltimore, Md.-based Brown Capital, after noting that large caps have dominated small caps over the last five years, returning about 17% compared to 5%, respectively. “I'm not in the business of making predictions of when and what time down to the second. But if you're a long-term investor, small companies are a place to be because of the innovation and that will come back.”
Small Caps Awaiting Rate Cuts
They indeed might not know exactly when small caps will begin to outperform large caps, but the panel members noted that small caps usually perform well in a low-rate environment, so the asset class is poised to gain steam again if or when the Federal Reserve begins to cut rates, at least once, likely before the end of the year.
In her well-attended keynote address to kick off the Morningstar conference last Wednesday, Bank of America’s Savita Subramanian flatly advised the overflow audience to hold off on investing in small caps until rates fall.
San Jose of J.P. Morgan explained that both relatively weaker fundamentals and macro factors like high rates have restrained small-cap stocks over the years. Small caps tend to perform better when rates are low because they usually have more leverage and floating-rate debt on their balance sheets and so are more sensitive to swings in rates than larger companies.
“If anyone in this room can tell you when (the Federal Reserve will cut rates) sign me up because I would buy (small caps) then too,” said San Jose, noting that investors at the beginning of the year were expecting up to six rate cuts in 2024. “Maybe we get one or two. What we do know is that rates are going to come down or at least stop going up and we need to do the work on small caps today to sort of layer into it and build out that diversified portfolio.”
In addition, small-cap companies had “somewhat of an earnings recession” coming out of the COVID pandemic, according to the fund manager. “So, I think from a fundamental basis, small caps were not looking as attractive over the last two years,” he said. “We think we’re on the cusp of that changing” and the sector’s earnings outlook looks better than 2023 or two years ago. “So, we also feel very good about where small caps are today.”
San Jose also reminded the audience that small-cap companies, along with other businesses, took advantage of the zero-rate environment to refinance debt. Their “balance sheets look much better than I think people are crediting them for,” he said.
Peck of Fidelity said she’s finding that a “lot of opportunities globally” are not surprising, given that valuations for U.S. stocks, both large and small caps, have risen relative to international equities. Peck is co-manager of Fidelity Low-Priced Stock fund, which Morningstar rates five stars and categorized as a mid-cap value offering.
“Some particular geographies and areas where we’re finding lot of ideas are in the U.K. across all sectors,” she said. “We’re finding opportunities in Japan, in industrials and small cap consumer companies.”
Finding Opportunities In Cyclicals, Regional Banks
In the U.S., the fund manager is also seeking “lots of opportunities in the cyclical parts of the market,” namely industrials, materials, consumer discretionary and “even some regional banks, which are probably not really popular,” Peck said. According to Morningstar, the top three sectors in Peck’s Low-Priced fund are industrials, technology and financial services.
San Jose, whose investment strategy is “100% domestically focused,” said he’s also finding ideas in many of the areas Peck mentioned. In industrials, for example, the J.P. Morgan fund manager said the building products business is poised to benefit from interest rates potentially easing.
In addition, the manager said he’s spending “a lot of time” on some regional banks in the Midwest. San Jose, who focuses on companies of “high quality,” said he’s always been underweight banks, but “depressed valuations” caused him to “inch back into some higher quality banks” at the beginning of this year. These banks are “really good underwriters” boasting “discipline management teams,” he said.
Lee, who heads a firm with $9.5 billion assets under management as of March 31 and focuses mainly on growth stocks, pointed out that his firm’s portfolios are generally titled toward areas such as technology and healthcare. Like the other managers, Lee said “we’re finding value across the board,” adding that his team has been looking at some consumer companies. “But the majority (we’re) looking at is in information technology.” Indeed, the top three sectors in Brown Capital’s Small Company Fund, for example, were healthcare, business services and information-knowledge management at the end of March.
Not surprisingly, the session on small caps eventually turned to artificial intelligence and the technology’s impact on the mutual fund managers’ investment strategies. According to the managers, they aren’t necessarily looking for the next AI company, but they spend much of the time asking companies how they’re regarding the potential risks and benefits of AI. “We look at tangential ways to play AI rather than the most obvious, direct way,” said San Jose of J.P. Morgan.
Moderator Tony Thomas, associate director of Equity Strategies at Morningstar Research Services, said a couple of months ago he and two colleagues were building a U.S. equity portfolio and the two suggested allocating only 2% of the assets to small caps. Their main argument was that larger companies have size, scale and financial resources at their disposal.
Small Caps Deserve More Than 2% Allocation?
So, asked Thomas, can small caps still compete?
Those Morningstar colleagues who would allocate only 2% to a model portfolio “should be looking for another job,” Lee of Brown Capital said jokingly, while Fidelity’s Peck said she’s able to find many companies “adaptive and resilient” enough to compete against larger rivals.
“We have a lot of luck with companies who aren’t of course trying to go against a Google or Amazon,” she said. “But they’re in a market that’s too small for many of these large companies to care about.”
San Jose of J.P. Morgan added he’s finding industrial cyclicals with high-teens, 20% margin that surpasses the profit of the average large cap’s. “And we find companies that can improve those margins, 30, 50, a hundred basis points per year,” he continued.
Finally, the managers said that, with more private companies delaying going public, this trend might be reducing the number of public companies, but it isn’t affecting much their investment opportunities. “Especially globally there are thousands of companies to invest upon,” affirmed Peck. “There’re still so many to look at and evaluate that we’re never running out of ideas.”
In a separate session, Bank of America’s Subramanian focused her address at the Morningstar conference on the attraction of large-cap value stocks. But the first questioner during the question-and-answer session asked the market strategist about her take on small-caps.
Subramanian, head of equity strategy and head of US equity and quantitative strategy at Bank of America Global Research, was eager to weigh in on the asset class she called the “forgotten territory.”
BofA: Don’t Buy Small Caps Until Rates Drop
“I really did want to talk about this,” the strategist said. Like the fund managers on the small-cap panel, she talked about the impact of private companies incubating in the private market longer rather than going public, mostly wary of the intense scrutiny of being a public business.
She pointed out that in 2022 when rates zoomed from zero to 5%, twice as many Standard and Poor’s 500 Index companies dropped into the Russell 2000, the small-cap stock market index, as there were Russell 2000 companies graduating into the large-cap S&P. That was the opposite trend one would see in a “normal year,” she said.
“So, in a way, the Russell 2000 is kind of half good companies that are going to benefit from this reassuring theme from U.S. job growth, from all the wonderful things that could happen in the U.S. over the next 10 years,” Subramanian said. “But then half of it is like the land of the forgotten, like misfit toys.”
These are companies, she explained, that are potentially just “bleeding out cash” and aren't necessarily “viable” in a higher interest rate environment. “Why own small caps until the Fed starts cutting interest rates and we're going back to zero rates,” Subramanian told the audience. “But don’t own them until then.”