Small caps looking less attractive as they face higher risk
In our view small-cap stocks as an asset class are primarily a trade on the risk outlook - if you are bullish about the macro-economic picture then small caps are where you want exposure. Their riskier, higher-beta and higher-volatility profile means they are likely to be more leveraged to an improving global outlook. We prefer large caps at this juncture, given our more muted outlook for global recovery relative to the consensus, the attractive relative valuations of large caps and recent small-cap outperformance.
Since the March 2009 lows, smaller companies in the S&P 500 have on average recovered 82%, compared to a relatively ‘smaller’ 55% gain for large caps. This strong outperformance of small caps has been based on the premise of a global economic recovery. Hopes of a strong economic rebound were dashed when Greek debt was downgraded in April by ratings agency S&P and the market pondered the potential ramifications of contagion spreading across the rest of Europe.
This has severely impacted risk appetite, with small & large caps having fallen 13.7% and 11.4%, respectively, since the downgrade. The larger losses for small caps highlight the sensitivity they have to risk.
Historically, small caps have tended to have lower valuations (cheaper), mainly due to the fact that smaller companies generally have more volatile earnings streams and shorter track records for delivering profit. However, our valuations, comparing a combination of earnings yields and book values for the MSCI US Index, suggests we have not seen such attractive relative valuations for large caps since the mid-90s (see the chart opposite). This turn of events has been brought about by speculation of an economic recovery, prompting a strong rally in small caps before real earnings have been delivered.
A recent survey by the Federal Reserve Bank of Atlanta has dispelled a myth that the lack of success for small caps in delivering earnings gains has been due to unfavourable lending terms. The top two reasons for small companies not seeking loans, according to the survey, were that sales did not warrant it and that they had sufficient cash on hand. Less than 10% said that unfavourable terms were the reason.
Our analysis of quarterly earnings results shows that, while the sales and profits of both small and large companies were hard hit in the second and third quarters of 2009, large caps were less impacted and have subsequently enjoyed a strong recovery. Small caps are now recovering, but data show they have generally lagged large caps by one quarter and the rebound in sales and earnings has been less pronounced than for their larger peers.
While we see the equity markets in general as being attractively valued at the moment, further hurdles need to be overcome to emerge from a higher-risk environment. The main hurdles we see are the prospect of further downward revisions of corporate earnings and GDP growth outlooks, and the need for European banks to raise further capital. We continue to favour large caps while these risks remain, and given their more attractive valuations and stronger earnings growth versus small caps.
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