Market commentary equities: Are small caps poised for a comeback?

Looking at the long-term performance of small caps relative to large caps paints a compelling picture. In both the US and Europe, small caps have historically outperformed their larger counterparts over the long term, particularly since the turn of the millennium. However, small caps have struggled in recent years and have underperformed significantly since the onset of the Covid crisis, particularly over the last three years. This underperformance is in line with the higher risks often associated with small cap stocks – they tend to be more indebted and more sensitive to business and interest rate cycles. The surge in inflation and rising interest rates since 2021 have further hampered their performance.

Changing economic landscape

Today, the economic outlook is shifting. The Federal Reserve and the European Central Bank have pivoted their interest rate policies initiating the first easing cycle since 2019. While rising interest rates typically challenge small companies due to their higher debt levels and sensitivity to borrowing costs, a more accommodative stance from central banks could benefit small caps, as borrowing costs stabilise or decline. In addition, smaller companies, which are less able to pass on rising costs due to lower pricing power, may see improved profitability as inflationary pressures ease. The current consumer price index (CPI) figures, hovering around 2 % in developed markets, point to price stability.

Valuation: An attractive entry point?

While valuation alone isn’t always a reliable predictor of returns, it does indicate the relative attractiveness of small caps, especially when coupled with earnings growth.

The recent underperformance of the small caps has driven down their valuations. For both US and European stocks, small caps are now trading at more attractive forward price-to-earnings (P/E) ratios. In the US in particular, the valuation gap between small and large caps is historically wide. This spread has not persisted over the long term as smaller companies – prior to the rise of the “Magnificent 7” mega-cap tech giants – tended to be more profitable and grow faster, justifying their high valuations.

The key question remains: Is today’s lower valuation of small caps merely a reflection of their lower profitability relative to the mega-cap tech giants?

Earnings outlook

The data suggests otherwise. Realised earnings have been higher for the US mid and small caps and projected earnings growth for US small-caps are only slightly below that of large-caps, with growth already exceeding expectations in many cases. In Europe, small cap earnings are projected to outpace large caps over the next three years.

This combination of attractive valuations and promising earnings growth points to a strong investment opportunity in the small-cap segment.

A rebound on the horizon?

In summary, small caps are well positioned for a rebound if economic conditions improve, inflation moderates, and interest rates stabilise. Many analysts forecast a more favourable outlook for small caps in late 2024 or 2025, as the macroeconomic environment becomes clearer.

Why Quoniam’s systematic approach to small caps makes sense

Quoniam’s systematic investment approach offers distinct advantages in identifying and capitalising on opportunities in the small cap space. Our proprietary models analyse an extensive universe of equities, including 3,000 European stocks, many of which are thinly covered – or not covered at all – by traditional analysts. This under-researched segment offers inefficiencies that our quantitative strategies are designed to exploit, allowing us to uncover hidden value in small cap stocks.

A key differentiator for Quoniam is our fully integrated in-house trading desk, which is essential for cost-effective and seamless portfolio implementation. Our trading desk ensures precise execution by utilising multiple venues, applying strict pre- and post-trade cost analysis, and a focus on minimising transaction costs. This capability allows us to efficiently bring portfolios to life, even in less liquid small cap stocks, where trading costs can quickly erode returns without the right expertise.

As can be seen in the chart below, there is a clear trade-off between forecasting accuracy and liquidity. Generally, the lower the liquidity of a stock, the stronger the correlation between forecast and realised returns within a systematic framework. However, this comes at a price: As liquidity decreases, trading costs tend to rise. Over the past three years, Quoniam has achieved a minimal implementation shortfall of just 8 basis points in developed market equities. For mid cap stocks (market caps between USD 2.5 bn and USD 10 bn), the market impact rose to 34 basis points, while for small caps (under USD 2.5 bn), it reached 49 basis points. These competitive results demonstrate our ability to balance the potential for higher returns in less liquid stocks with the need for cost-efficient trading.

In short, Quoniam’s systematic approach not only identifies attractive small cap opportunities, but also ensures that these opportunities are executed with precision, adding value through both superior stock selection and cost-efficient portfolio implementation.