Not all small caps are created equal

A change in sentiment
In June, US CPI headline and core inflation were lower than expected. The new evidence that inflation is returning towards the Fed target raised the probability of interest rates will be reduced in the remainder of 2024. According to futures contracts, a 0.25% reduction in the fed funds rate is fully priced in at the Federal Open Markets Committee (FOMC) September meeting.¹ 

This led to a change in sentiment from investors who sold mega-cap technology stocks and turned to other parts of the market that had underperformed year-to-date (YTD), namely small-cap stocks. The Russell 2000 index, which tracks the performance of US smaller companies, had the largest percentage increase since November 2023, when the Fed’s pause on its interest rate hike cycle triggered a similar rally in the sector. From a technical point of view, the index broke the top of its 2-year range, with investors remaining confident this market can continue to trend higher (see Chart 1).

Chart 1 – Russell 2000 Index broke its 2-year range

Source: LSEG Data & Analytics and EFGAM. Data as of 16 July 2024.

Key drivers: profitability, valuation, and cash flow generation
Small companies are more sensitive to interest rates, as they are more dependent on external financing for growth than large caps. Therefore, the potential for lower interest rates in the future would support the sector. However, this could become an issue for some firms if the easing of monetary policy, as a result of a deceleration in economic activity, negatively affects profitability. Investors should therefore tread with caution on how they approach their allocation to the sector as not all small companies are equal. Factors such as profitability, valuation and cash flow generation will be the key drivers to future returns for investors.

There are considerable differences among firms in the Russell 2000 index, with almost a quarter of them remaining unprofitable. These firms are unlikely to turn profitable as a result of one, or two, 25-basis-point rate cuts from the Fed this year. Therefore, it is important to be selective.

Chart 2 – US small-cap stocks forward P/E ratio relative to Large-cap stocks (1976-2024)

Source: Empirical Research Partners Analysis

By excluding firms with negative forward earnings, the forward Price-to-Earnings ratio of smaller companies relative to large-cap stocks looks attractive. In fact, valuations of profitable US small caps are at the lowest level since the year 2000 (see Chart 2). These are precisely the type of stocks that the New Capital US Small Cap Growth fund focuses on – highlighted by strong profit growth and relatively attractive valuations.

Additionally, it is important to distinguish between firms which can generate enough cash rather than focus just on its growth rate over time. The difference in returns between the highest and lowest quintiles of smaller companies based on free cash flow margins and free cash flow yields have been greater relative to those based solely on annual sales growth rates (see Chart 3).

Chart 3 – Small-cap relative returns of the highest and lowest quintiles of select factors (1965-2024)

Source: Empirical Research Partners Analysis

Investors should remain selective
In conclusion, small cap companies have rallied in response to increased expectations of interest rate cuts before yearend. However, signs of economic weakness in the US economy could become an issue for unprofitable firms. Investors should remain selective in this space, avoiding passive strategies in favour of actively managed ones. While sales and earnings growth is a pre-requisite for small cap performance, there is significant disparity between top and bottom performers. Additional focus should therefore be placed on firms’ profitability, valuation and cash flow generation in addition to sales growth rates.

¹CME FedWatch tool, data from 16 July 2024.