Are small cap stocks poised for a rebound?

November 14, 2024

This article was written by Polaris Capital.

Small cap stocks have been a profitable asset class over time, as they benefit from what academics refer to as the “small cap premium”. It is the idea that small caps are less efficient, carry a higher level of risk, and are more prone to failure (than large caps), thus requiring a higher level of return to attract investors. For example, from the end of 2000 through the end of 2023, global small cap equities, as measured by the MSCI World Small Cap Index, returned 7.85% compared with 5.58% for global large cap equities, as measured by the MSCI World Large Cap Index. (Source: Factset, in AUD)

However, in recent years, this small cap premium has seemingly vanished; there has been a significant divergence in performance between the two asset classes with global large cap stocks significantly outperforming. In this insight, we explore why that is the case and why we think this trend is set to normalise.

An ultra-low rate environment favoured all

Following the Global Financial Crisis of 2008, the global economy entered into a period of prolonged low, and in some cases, zero, interest rates. With access to cheap capital, investors piled into stocks across the cap-spectrum in search of excess returns with little perceived risk. During this period, most stock markets, regardless of sector, region, or market cap, performed well and investors experienced outsized gains. This held especially true for large caps, which borrowed on the cheap and forged ahead with both organic and acquisitive growth opportunities. Merger and acquisition (M&A) activity ensued in this environment with the number of M&A deals increasing materially from December 2008 through March of 2022. (source: Institute for Mergers, Acquisitions & Alliances)

Per the chart below, global small- and large-cap stocks both performed well in the ultra-low rate environment of December 2008 – March 2022. In fact, the MSCI Global Small Cap Index returned 12.47%, outperforming the MSCI Global Large Cap Index by 128 basis points.

Small & large cap equity returns during low and high rate environments^*

Throughout the period of low rates (November 2008-March 2022), consumers spent, companies hired, the global economy chugged along, and inflation began to tick up. In the U.S. alone, the Consumer Price Index rose 1.2% in March 2022, culminating in an 8.5% raise within the year; this marked the highest year-over-year increase in 40 years. Other countries were in a similar predicament, with Europe especially impacted by global energy market costs, rising due to the Russia-Ukraine war and general consumption trends. Even Japan, which averaged 0.8% in the 10 years to 2022, trended higher, with the CPI up 2.5%. In response to these, and other, catalysts, in March of 2022, global central banks began to raise interest rates to combat inflation. 

The Federal Reserve raised interest rates 11 times in 2022; the European Central Bank raised fixed rates to 0.5% in July, and then raised the rate in September, November and December of 2022, while continuing through 2023 and mid-2024; the Bank of England raised rates five times in 2022, and subsequently raised rates on a near-monthly basis through August 2023.

On a rising rate backdrop, small-cap stocks started to significantly underperform their large-cap counterparts. In this high-rate environment, which we consider to be March 2022 – August 2024, global small cap stocks underperformed global large cap stocks by almost 700 basis points as shown on the chart above.

Why high interest rates disproportionally impact small caps

Macroeconomic uncertainty led investors to shift focus to traditionally less-volatile larger-cap stocks.

Private equity and M&A firms were forced to focus on their own levered portfolios rather than seek out new small cap acquisition targets. From April 1, 2022 through August 31, 2024 M&A activity globally declined nearly 56%. (Source: Institute for Mergers, Acquisitions & Alliances)

Access to free capital began to dry up. Smaller companies access debt via bank financing, which tends to be variable rate and shorter duration in nature. Small cap companies have more floating rate debt with 45% of aggregated Russell 2000 Index debt (excluding financials) classified as floating rate compared to only 9% of the S&P 500 Index debt. Large cap companies have access to the corporate bond market, which tends to be longer duration, fixed rate debt.

During the period of ultra-low interest rates, small cap companies benefitted from the fact that variable rates were so low. However, as rates rose, the cost of funding for smaller companies rose in lockstep with the rise in central bank rates, which increased interest expenses and impacted cash flows. In essence, the financing structure presented hurdles to small cap companies.

Time to cut rates; time to re-evaluate small caps

With rates at elevated levels for an extended period, global economies have shown signs of stagnation. We expect to see rate cuts and a return to more a normalized rate environment. Already, we have seen the Bank of Canada, Bank of England, and European Central Bank lower rates. In June, July and September 2024, the BoC made three back-to-back rate cuts, each at 25 basis points (bps) and most recently, a 50bp cut in October; on August 1 2024, the BoE made an introductory cut by 25 bps to 5%, the first interest rate drop in four years and then another 25 bps cut in November to 4.75%; and in early September, the ECB lowered its deposit rate by 25 bps to 3.50% and then again in October to 3.25%, following up on a similar cut in June. Importantly, we are not arguing that small cap equities require an ultra-low rate environment to generate attractive returns. In fact, we think rates will remain higher for longer, but as the terminal rate has been reached and will trend lower, it should close the performance gap between large and small cap companies. Just as an ultra-low rate environment benefitted multi-cap companies, and a higher rate environment benefitted larger companies, a more normalised rate environment should lead to a convergence between the two asset classes.

Polaris employs an all-cap, all-country approach, which provides the flexibility to find some of the best value opportunities available across the market. The result is a well-diversified portfolio with a higher exposure to small-and mid-cap companies than the benchmark.

The Polaris Global Equity Fund is proudly brought to you by Macquarie Professional Series.

The Target Market Determination (TMD), available at macquarie.com/mam/tmd, includes a description of the class of consumers for whom the Fund is likely to be consistent with their objectives, financial situation and needs.