I love good food, always have. Enough to have it front and centre in an asset allocation piece focused on the prevailing virtues of US small caps? Absolutely. Ironically though, it was a disappointing meal out with some friends which sparked the initial parallels.
We’ve all been there, when hopes of being transported to a rustic Italian eatery are abruptly quashed by overcooked pasta, and the intermittent bellowing of London sirens.
However, barring the occasional disappointment, chances are unless you have an aspiring Gordon Ramsay in the family, some of your best meals will be when eating out. In other words, there will be a long-term performance differential between the short rib ragu made at your local Italian and your mid-week spag bol.
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Hopefully I haven’t lost the diehard asset allocators yet, as if now we substitute that short rib ragu with small caps and your spag bol with large caps we have effectively summarised part of the findings of Eugene Fama and Ken French in their world-renowned study of the three-factor model back in 1993.
It was here where the pair showed that small-cap stocks have historically delivered higher returns over the long term compared to their large-cap counterparts. A phenomenon which can be attributed to the risk-return trade-off, where investors demand higher returns for the increased risk associated with smaller companies.
Of course, higher risk means there will be periods when small caps disappoint, adding a degree of volatility to your portfolio. But if deemed suitable for the risk tolerance of a strategy, an allocation must be considered, as they can be an important driver of capital growth over the long term.
But rather than being something to consider, recent market dynamics have made small caps an asset that simply cannot be ignored.
Rightly or wrongly, on the back of an improvement in prospects for the US economy and an increased likelihood of a soft landing being engineered by the Federal Reserve, investors have flocked in their masses towards the magnificent seven, the poster children of present-day corporate America. Given their sizable weighting in indices such as the S&P 500, such demand has pushed up multiples within the US large-cap space, and now relative to small caps are trading at 20-year highs.
So right now, US small caps are looking really good value versus their large cap counterparts with the discrepancy presenting a strategic entry point for investors seeking to capitalise on the potential for outsized gains.
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Interestingly, you would typically expect such an opportunity to present itself in periods of economic stress. However, despite pockets of weakness, the US economy continues to prove resilient in the face of tighter monetary policy.
Such resilience, particularly in the context of the emerging narrative around a potential soft landing, creates a conducive environment for US small-cap stocks to thrive, with the robust economic backdrop expected to support the growth and profitability of smaller companies.
So, we have the perfect marriage, an asset poised to benefit from good fundamentals but trading at attractive valuations; akin to stumbling across a hidden gem with amazing food at a reasonable price (the latter virtually unheard of in London).
But imagine how excited you would be if that hidden gem announced plans to open another restaurant in your local town in around three-to-six months’ time. Very excited indeed.
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Well, small-cap investors are looking to potential rate cuts from the Federal Reserve with equal enthusiasm. This is because small caps tend to have a notable inverse correlation with interest rates – as rates fall, prices tend to rise. So with the current market sentiment leaning towards expectations of interest rate cuts rather than further hikes, small-cap stocks are positioned to benefit significantly.
This shift in monetary policy expectations could therefore act as a catalyst for strong returns in the small-cap segment helping to support the prevailing fundamental tailwinds. Adding to this the current attractive valuation backdrop makes US small caps harder to ignore than that short rib ragu five minutes down the road.
Louis Hutchings is a portfolio manager at Nedgroup
