U.S. small caps — investment underdogs?

Global Outlook

Tim Skiendzielewski, Investment Director, Equities

The Tokyo summer games, which were delayed a year because of the global coronavirus pandemic, are a reminder of just how much has happened since the last games in Rio.

In 2016, U.S. President Joe Biden was wrapping up his eight-year run as vice president under Barack Obama before the election of Donald Trump. Since Rio, major cellular providers have rolled out 5G networks and there have been 13 new iterations of the Apple iPhone.1 There were many fears about the mosquito-borne Zika virus, but Covid-19 didn’t exist yet.

While much has changed in the world — not least of which the social and political landscape of the U.S.— many of the trends in equity markets have remained the same. Just as they did in the run-up to the 2016 games, small caps have lagged their larger counterparts, aided by the outsized performance of the FAANG (Facebook, Amazon, Apple, Netflix and Google/Alphabet) stocks. 

Additionally, notwithstanding the recent resurgence of ‘value’ stocks, the growth factor has worked exceedingly well over the past five years, aided by the pervasiveness of technology across industries and advances in healthcare.Looking ahead, with accelerating domestic growth on the horizon and relative valuations favouring smaller companies, we see significant potential in U.S. small-cap asset class.

Following several years of underperformance, small caps could be poised for a comeback

Chart

Source: Bloomberg, 30 Jun 2021

Note: Excluding negative earnings

Rooting for the underdog

In the shadow of U.S. large-caps, many of which are household names that garner the most financial press, small caps are like the equity underdogs. However, therein lies the opportunity for investors. Smaller companies may not have the most well-known brands, the highest-profile management teams or the biggest balance sheets, but, like many sporting champions, they have focus and drive.

Smaller companies may not have the most well-known brands, the highest-profile management teams or the biggest balance sheets, but, like many sporting champions, they have focus and drive.

In many cases, small caps are singularly focused on a specific market niche or product. Thus, they’re able to be more innovative and nimble than their larger counterparts. This can lead to greater revenue growth potential and the ability to scale margins quickly — typically a good harbinger of strong shareholder returns.Additionally, smaller companies are often led by founders with significant equity stakes in the business. This creates good alignment of interest with minority shareholders — an important, but often overlooked, investment criterion.

Consider the software sector. It was long dominated by behemoths that operated across many sub-segments of the market and faced little competition. But, the advent of cloud-based operating and delivery models created an opportunity for smaller companies with differentiated product offerings and service levels to take market share. By virtue of having focused research and development programs, smaller software companies can develop significant ‘domain expertise’ and thus better serve customers and react more quickly to changes in the market than a ‘jack of all trades but master of none’ large company. 

We have seen this theme play out across several areas, but most notably in the payroll and human capital management space. This market historically had been served by a handful of entrenched competitors with outsized margins who had little incentive to innovate.This created an opening for a host of ‘born-in-the-cloud’ providers to slowly but surely take market share over the past decade. As a result, they’ve delivered robust revenue growth at expanding margins for shareholders. 

Striking while markets are hot?

Right now, markets are hot as evidenced by elevated initial public offering (IPO) activity, the resurgence of special purpose acquisition companies (SPACs) and overall robust returns in the face of a somewhat choppy economic recovery. While interesting investment opportunities in the small cap market abound, there’s also a wealth of cash on the sidelines and many eager venture and private capital managers ready to deploy funds. As a result, there’s significant capacity to fund innovative companies that have developed differentiated and compelling products and services. The opportunities in small caps, which are already significant, could continue to increase in the years ahead.

1 iPhone Life, “The Evolution of the iPhone: Every Model from 2007–2020,” April 8, 2021.

 

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