The major US benchmarks are off to a hot start in 2023, thanks in part to what’s called the January effect: when investors start buying stocks more aggressively after selling off their losses for tax harvesting in December.
That usually is a boon for markets — particularly high-upside small-cap stocks — and 2023 was no exception. The S&P 500 added more than 6% in January, and the small-cap-focused Russell 2000 managed even better, jumping nearly 10%.
We’re a week into February now, but there’s reason to believe the underlying market conditions of the January effect that make small-caps ripe for value could linger for months or even years to come.
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Que Nguyen, chief investment officer of equity strategies at Research Affiliates, believes small-cap stocks are significantly undervalued as an asset class. The reason, she says, is that small caps are growing faster than their larger peers in terms of sales, but their valuations aren’t keeping up.
The top 90% of global companies by market cap grew their sales by 25% from 2017 to 2021, but their valuation increased by 50%, Nguyen wrote in an article for Investment & Pensions Europe magazine last month. The bottom 10% (read: small caps) saw revenue growth of 53% but multiple expansion of only 7%.
That’s a six-fold increase in valuation for the big caps relative to the small caps.
Positioned for a rebound
“Large-cap technology platform companies in the US increasingly dominated the global economy, using their scale to build oligopolies,” Nguyen said. “As market share accrued to fewer firms, the valuations of these companies soared, driving their stock prices ever higher.”
Those soaring stock prices have created a gulf.
“This valuation disconnect underpins our view that small companies are poised for a significant rebound relative to large companies over the next few years,” Nguyen said.
According to her analysis, small-cap stocks are trading at a 25% discount to historical norms since 1989. When that’s happened previously, small caps have returned a premium of 3.7% relative to large caps over the subsequent five years.
Nguyen pointed to February 2000, when in the wake of the tech bubble, Research Afilliates’ model predicted a small-cap return premium of 4.6% over five years. That turned out to be a conservative estimate, as the next five years actually yielded an 8.2% premium.
That said, investors do need to be mindful of an uncertain environment and recognize that small-cap and large-cap stocks are inherently not going to trade at similar absolute valuation levels. Nguyen’s analysis expects small companies to trade at an aggregate discount of about 18% to larger companies on average.
“Historically, small companies tend to deliver higher growth rates, albeit with greater uncertainty,” Nguyen said. “The increasingly challenging inflation and growth landscape makes the near-term path harder to navigate for smaller companies. ... However, in the recovery, and over a five-year period, small companies tend to deliver revenue and earnings growth at rates higher than those of large caps.”
“In short, the size premium is ripe for harvesting.”
Contact Andrew Kessel at andrew.kessel@proactiveinvestors.com
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