Why 2024 may be the year when small caps bounce back

After lagging the wider market in the wake of aggressive monetary policy tightening, the evolving macroeconomic backdrop looks set to put small cap stocks back in the spotlight again.

Small caps  – companies with a market capitalization of between $300m and $2bn²  – are typically viewed as higher risk when compared to their large-cap counterparts. But because of their typical growth characteristics, the sharp increase in interest rates heavily dampened small caps’ performance in 2022 and 2023, despite decent financial results from many companies.³

Even so, at a global level, small caps achieved a still respectable total return of 17% over the 12-month period, though large caps delivered a stronger 24%.⁴  However, between the end of 2008 and the end of 2023 small caps have outperformed, delivering a cumulative return of 521% against 466% for the large cap index over the 15-year period – although past performance should not be seen as a guide to future returns.⁵

In addition, it’s also sometimes thought – incorrectly in our view – that small caps are often more volatile than their larger peers. Over the longer term, the difference appears relatively small, as shown in the chart below.⁶

Small cap versus large cap volatility

What’s more, the Sharpe ratio – which compares risk with return – is currently higher for the MSCI World Small Cap index than for the MSCI World Large Cap index, at 0.44⁷  versus 0.35 respectively.^{i 8}  A higher Sharpe ratio could signify a better historical risk-adjusted return.

Given the changing macroeconomic backdrop, we outline why many investors see potential value in small caps in 2024.

Lower rates and better valuations

Many investors believe interest rates have peaked, with markets now pricing in cuts across many major economies in 2024, something which could prove beneficial to small caps.

Higher interest rates can create a more difficult environment for small caps –  they can reduce investors’ risk appetite, prompting them to opt for assets potentially less sensitive to monetary policy while the increased cost of capital makes it more expensive and challenging for small caps to raise financing.

But as central banks appear to be broadly winning the battle against inflation,  investors expect the markets should see both the Federal Reserve and the European Central Bank (ECB) start to ease in June – although the ECB will likely follow the lead of the US central bank.

As interest rates start to ease and the broader macroeconomic outlook improves, we believe there could be more flows into small caps as risk appetite starts to rise once again.

A possible advantage of the small caps route, is that it made the asset class’s valuations more attractive to many investors with stocks roughly trading in line with large caps – they would usually trade at a premium. Even following December 2023’s strong equity rally, the premium in Europe for example rose from 0.6% at the end of September 2023 to 2.4% by the end of the year – still historically low.^{i  9}

Potentially superior earnings growth

Small caps can be highly innovative and more agile in operations and business models when responding to potentially challenging demands or new opportunities. They are also a hive of technological innovation which is becoming increasingly apparent in the transition to clean energy, with small companies benefiting from investment in solar energy, and other clean technologies. 

Earnings growth – small caps versus large caps¹⁰

Fresh opportunities

Small caps may have slipped under the radar for some investors in recent years, but the rate tightening cycle looks to be coming to its nadir. This, alongside the fact that trading valuations are historically low compared to large caps, could be a compelling combination for investors given the sector’s potentially superior earnings growth prospects. However, as always, given small caps’ sensitivity to macroeconomic changes, active management will remain crucial. A more dynamic merger and acquisitions market would be another trigger for the asset class to become more attractive to investors.

Companies shown are for illustrative purposes only. It does not constitute investment research or financial analysis relating to transactions in financial instruments, nor does it constitute an offer to buy or sell any investments.

Risk Warning

Investment involves risk including the loss of capital.

The information has been established on the basis of data, projections, forecasts, anticipations and hypothesis which are subjective. This analysis and conclusions are the expression of an opinion, based on available data at a specific date. Due to the subjective aspect of these analyses, the effective evolution of the economic variables and values of the financial markets could be significantly different for the projections, forecast, anticipations and hypothesis which are communicated in this material.