Where is the small-cap revolution?

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Good morning. US stocks posted two consecutive daily gains yesterday for the first time in a long time, after three volatile weeks. We’ll see if the calm holds after last night’s debate. Send us your comments by email: robert.armstrong@ft.com and aiden.reiter@ft.com.

What small-cap revolution?

Six weeks ago we wrote about what seemed like the beginning of a small cap revolutionSmall-cap companies, after years of underperformance, went crazy A week after strong inflation data fueled hopes for a rate cut, we’re left wondering: is this a blip or a change in leadership?

It was a setback. Since that strange week, big business has taken control again.

While we have seen a shift in leadership in the index, as tech stocks have lagged behind defensives and interest rate bets, small caps are lagging again.

The standard justification for the small-cap renaissance is twofold. We are told that small-caps are more heavily indebted, so they are disproportionately affected by higher interest rates. Interest rate cuts should therefore benefit them more. And small-caps are more sensitive to the economy and have reacted poorly to the turmoil of recent years. If the Fed manages a soft landing, discounted small-cap stocks could take off.

The Federal Reserve will begin cutting rates this month and the US economy is… On the way of a soft landing. So there is still hope for small caps, but we are a bit skeptical.

Let’s start with business performance. Yesterday, We look at how the S&P 500’s net profit margins have been widening for years. Part of the explanation is that big tech companies, which have become an increasingly large part of the index, have wide margins. Although margins are also rising for small-cap companies, large companies are increasing their advantage. Here are the spreads in net margins between the S&P 100, which includes only the largest U.S. companies, and the simply large S&P 500, the mid-cap S&P 400, and the small-cap S&P 600:

Small businesses have increasingly fallen behind larger companies in terms of profitability. Recently, this is likely partly due to the pricing power that large companies had during the pandemic, but the trend is older. Ian Harnett of Absolute Strategy pointed out to us that this may also reflect large companies putting pressure on smaller suppliers. It is also possible, as we mentioned in July, that private equity has been buying up the most profitable small companies. But whatever the causes, there is little reason to expect this long-standing trend to change in the near future.

There is some truth to the idea that small-cap companies have been hit harder than large-cap companies by rising interest rates, and so will get more relief when rates fall. But only some. We compared nonfinancial companies in the S&P 600 in 2019 and 2023. In 2023, net interest expense was no higher relative to operating earnings than in 2019, and the aggregate interest rate companies paid on their debt was only slightly higher. In other words, the debt burden barely increased as rates rose, because earnings grew faster than debt payments. Small-cap companies don’t have much to gain from falling rates.

What did happen is that for large S&P 500 companies, the debt burden actually fell between 2019 and 2023, because operating profits rose so much and the effective interest rate actually fell, as many companies refinanced before the Fed started raising rates.

Small-cap companies remain cheap relative to large-cap companies on a price/earnings basis. And, according to Charles Cara of Absolute Strategy, “Some of the large small-cap companies that experienced a collapse in aggregate margins [during 2020] “We are starting to see an improvement.”

But it seems unlikely, at least to us, that we will see a dramatic revival of small-caps. Margins and debt point to modest earnings, relative to larger companies. We are also unclear about the economic outlook. While there are signs of a soft landing, there could still be economic turbulence after the rate drop, which would hurt cyclical small-caps. From Jon Adams of Calamos Wealth Management:

The overall conclusion is that we are not yet at the point of declaring that small caps must outperform. We are monitoring them closely; in July, small caps showed signs of being able to outperform. [but] Since then, they have lagged behind. We need to see more evidence on the prospects for rate cuts… and whether there will be a slowdown in the economy.

(Armstrong and Reiter)

A good read

in repeat.