Global Perspectives: Why small caps appear poised for a day in the sun

Adam Hetts: Welcome back to Global Perspectives. I’m your host, Adam Hetts, and today we’ll dive into U.S. small cap with Jonathan Coleman and Justin Tugman, both Janus Henderson Portfolio Managers in the U.S. small-cap space. Jonathan is here with me in Denver and Justin is joining from Chicago. So, Jonathan, Justin: Thanks for helping us out today, guys.

Even though the U.S. economy feels late in the cycle, it also feels that some of the risk of a downturn might already be priced in. If that’s the case, small-cap companies might be poised to outperform the broader market sooner than some investors expect. So, Jonathan, can you get us started by laying out how smaller companies typically perform going into and coming out of a recession, at least historically speaking?

Jonathan Coleman: Yes. Thanks, Adam. It’s an interesting perspective on small-cap companies. They tend to anticipate recessionary periods well before they occur, and they tend to perform quite well even during the recessions and coming out of recessions. We’ve gone back and looked at the last six recessionary periods in the United States economy, and what we’ve seen is that the small-cap market tends to underperform going in, but then during the recessionary period, the performance is about flattish. On average, it’s down about 2%-3% during recessionary periods.

Then what’s really exciting, as we think about where we are potentially in the economic cycle approaching a slowdown, is that small caps in these six prior recessionary periods have really led the market out of the downturn. So, in the first 12 months after the recession, on average, the small-cap market is up about 30%. So, when we look at it, we see a relatively attractive risk-reward, assuming that we may be going into a recession.

Hetts: That’s a great starter for thinking about small caps as that early-cycle trade. It means they’re the first victims of a slowdown earlier on but then also the first beneficiaries, to your point, of the recovery, even earlier on than the large-cap space.

So, then, Justin, could you talk a little bit about how to maximize those characteristics in small cap? I think whether our listeners are in the recession camp or not, we can all agree it’s at least some kind of slowdown coming at us. So, compared to a bull market, what are some characteristics in small companies?

Tugman: Sure, Adam. I think it’s important to note that really the characteristics that we’re looking for in companies doesn’t change throughout the course of the cycle: strong balance sheets, consistent free cash flow generation, profitable companies, and either healthy or improving return on invested capital. Now, there’s certainly some times when I think the valuations may warrant, and particularly the fundamentals may also warrant, taking on a bit more risk, but I think when you look at the current environment, in our view it doesn’t make sense to be taking on added risk right now.

We’re obviously seeing companies with more leverage on the balance sheet begin to underperform, but then also those that carry a lot of debt are starting to see their interest expense go up, and that’s leading to hits to the earnings line. So for us, that has been always a stalwart that we focus on, is those companies with the strong balance sheets, because when you have those, when times get rough, it provides flexibility. Companies can either return capital to shareholders or they can make accretive acquisitions.

I think also have the companies been over-earning over the past few years, and is it sustainable? Those that don’t have a lot of volatility in their earnings, we just think that those offer better, longer-term, more consistent plays over time.

I would also say that, given the environment that we’re in, trying to avoid or at least limiting exposure to companies that have meaningful risk of potential write-downs on the balance sheet. So, think about companies with a lot of real estate exposure where we’re starting to see valuations come down, but then also those companies that use a lot of leverage in their business model – so, notably, things like real estate investment trusts. Now, there will be certainly a time when valuations fully reflect the risks, but I think at this point we’re just not seeing enough of those opportunities yet.

Hetts: So, you’re talking about stable earnings, strong balance sheets. I think that’s right that a strong focus on quality in the space is important. Because even if we’re going to be really optimistic here and say a lot of the slowdown is already priced in and that it’s even mostly upside from here, there’s still going to be a lot of ongoing economic volatility and that’s going to create a ton of dispersion between winners and losers. So, aside from the quality concept you just walked through in general, let’s try to break down that dispersion in a couple of different other ways. So, first, how do valuations look in the value versus the growth segments of the small-cap market?

Coleman: In terms of talking about the growth segment of the market, we really see dispersion within growth and what we have termed in the last several years to be a market of haves and have-nots, where the moderate-growth companies that we would call the steady compounders that can grow 12%-15% a year trade at very attractive and modest valuations from our perspective. A lot of these companies have high-single-digit free cash flow yields as a percentage of their equity valuations and, as I said, are trading at 11, 12, or 13 times earnings.

In contrast, some of the faster-growing companies – many of whom in the small-cap growth segment tend to be still money-losing as they’re trying to reach their escape velocity – still trade at very robust valuations, typically on multiples of revenue that are in the mid to high single digits and, of course, no profitability in a lot of these segments. We still see the percentage of the growth benchmarks in terms of the weight of money-losing companies to be still very elevated relative to historic[al] levels, even though many of those stocks had significant drawdowns in 2022.

Hetts: And, Justin, just thinking across value and growth, with inflation and interest rate volatility being such big drivers of the slowdown potentially, how are you seeing this create dispersion in the small-cap space in general? And then, as part of that, can you talk a bit about navigating small-cap banks and all the headlines we have there, speaking of interest rate volatility?

Tugman: Yes. The interest rate moves that we’ve seen over the past year have certainly created some headwinds. As I mentioned earlier, we’re seeing those companies with more leverage on the balance sheet, that their cost of servicing debt has gone up, which has created pressure on the earnings profiles. Those companies that utilize a lot of leverage in their business models, they’ve come under pressure in the market and then, obviously, what we’ve seen with the banks over the past several months.

I think when you also look at it, one of the things that has made this a very difficult environment to really get your arms around has been the move that we’ve seen in the interest rates. We know that there’s going to be a lag in terms of monetary policy, and the question is going to be, when is that actually going to result in an economic slowdown? So far, we have not seen much of that. When we talk to a lot of the companies in the more cyclical industries, particularly industrials, they just haven’t seen it.

Now, there’s other areas where we’ve started to see potential signs of slowdown, things like consumer discretionary, with customers maybe beginning to be tapped out in terms of their spending prowess, but in general it has certainly created a lot of dislocations within the value space. What we’re starting to see is that the cyclical names are either priced as if we’ve hit peak earnings or, at the very least, I think the multiples have certainly come down to levels that we saw coming out of the Global Financial Crisis at around 13 times earnings. So it’s a question of how much risk there is to the earnings going forward and, if we have seen peak, what are the potential risks to those earnings?

I think in terms of the banks, it’s obviously been a little bit more of a challenge for the value benchmarks than the growth benchmarks. And I would say that this has been a very interesting one and one where, for the most part, everyone was worried about credit; eventually credit would become a problem. And that still is an outlying issue that may come to the forefront over the next few quarters. But I don’t think many people expected interest rate risk or effectively runs on the bank to be the catalyst for the massive selloff within the group.

To me, there’s phases of this banking cycle and the first question asked is, “Can my bank survive?” We’ve seen some that have not, and we’ve seen a lot that have, but there are still questions about some of those. Then, once we get past the survivability issue, it’s the question of, “How much will the earnings be hit?” Some of that is going to be the scramble to maintain or garner additional deposits. Your funding costs from the bank perspective are going up. Then I think particularly that has created some issues in terms of, are the banks really as cheap as they appear? Because the earnings numbers are likely incorrect.

Once we get past that, then there’s the ramifications. There’s going to be more regulatory scrutiny of the banks. It’s also going to be likely that we’re going to see lower returns and lower earnings for the banks. Number one will be the higher regulatory cost, but then second will be that they’re going to have to most likely carry more liquidity on the balance sheets. There’ll be less buybacks and those will be funds that just don’t earn as much money.

Then, once we get through that, then the market has got to adjust, and it’s got to understand and figure out what are the appropriate multiples to put on businesses that aren’t likely going to have as high of returns or as high of earnings potential as we once thought?

Coleman: I’d actually like to go back and just augment something that Justin was talking about as it relates to the small-cap market valuations as a whole. Even if we’re going into an economic slowdown and earnings estimates are too high by 15% or 20%, there’s a margin for safety there. So if you’re buying something at 12 times now and you’re not exactly right on the forward earnings projections, maybe you’re buying it at actually 14 times because the earnings come in a little lower, but that’s still a reasonable valuation and you’re not taking too much risk by being exposed to those companies that may experience a short-term period of slowdown if the economy slows.

Hetts: I’m glad you mentioned that, Jonathan, on valuations and multiples. Maybe we can dig into that a little bit more. So, I think most listeners are probably familiar with just S&P 500 [Index] multiples. Now, we’re talking around 19-ish. Then, depending over which time period you’re looking at, a 16 to 17 forward P/E [price-earnings] multiple on the S&P is a little more of a typical long-term average. So, if we derated from 19 to that 16 or 17, that’s a 10% impact on returns from that derating. For context, in 2022 we derated to the tune of roughly 20%. Within rounding, that’s what people experienced on the S&P returns. That was the duration effect within equities.

So that’s some of the caution that investors are feeling on the S&P, is that valuations are a little bit tight, and I guess you could at least call it unforgiving, relatively speaking compared to history. So it’s the opposite, that if earnings revisions are a little more painful than people expect, there’s not a lot of cushion you could expect in large-cap valuations. When you’re talking about that 12 or 13 multiple in the small-cap space and maybe that turns into effectively a 14 if there are some earnings revisions, what is long-term average multiples in the small-cap space? How much more could multiples absorb and creep up just to get to long-term averages there?

Coleman: I think again you have to delineate between segments of the small-cap market. So, as I was describing before, this market of haves and have-nots … We have a cohort of stocks that are very fast-growing, that are still money-losing, that have elevated valuations, but for the stable, steady-Eddie businesses, very attractive valuations relative to long-term averages.

So, I’d say for those cohort of companies that are trading in the low double-digit range, that’s moderately below long-term averages, and so we do have that buffer that you’re describing. Even if earnings were to slow down, I think the expectation would be that the small-cap market might be flattish in that type of environment. That’s, as I was saying earlier, what we’ve seen in prior economic slowdowns in recessionary periods in the U.S.

Hetts: Thanks. As far as headlines, we talked about banks, but then some things that aren’t in the headlines as much anymore would be COVID, thankfully, and geopolitics, at least at the moment, but they’ve brought this long-term trend of deglobalization and onshoring. So, then, how can smaller companies look to benefit from those trends, and are there any other long-term trends I might be missing that you think might benefit the small-cap asset class?

Tugman: Well, I think one of the themes that we have been big believers in for the past few years is onshoring to the U.S. I think one of the things that COVID did is really highlighted some of the weaknesses in the supply chain and being completely dependent on your ability to source product or materials from countries halfway around the world.

I think that the big takeaway there is that we are seeing early signs of, I’d say, onshoring or reshoring to the U.S. We think that’s going to continue. It’s our belief that that may lead to stickier inflation just because of the cost in the U.S.: It’s a little bit higher with doing business, but it’s a little bit more secure. I don’t think that that’s a bad thing, either, for small caps. But when you look at the small caps, if we’re right on the reshoring to the U.S., roughly 80% of their revenues for small caps are generated domestically. If we continue to see better economic growth and particularly investment in the U.S., I think that sets up very well for small caps in general.

I think the other thing that we’re seeing is, certainly a lot of money is being spent out of Washington, D.C. that will help domestics and particularly the small caps, when you think about infrastructure, whether it’s roads, highways, if you look at the clean energy transition. And I think also the fact that you’re seeing money being spent to increase things [like] semiconductor capacity in the U.S. Well, that requires building fab[rication] facilities, and those are all benefits to the small caps.

Coleman: I really agree with some of Justin’s points there and would just add that we think that this is going to be a very long-term trend. If you look at some long-term perspective, it took 30 to 40 years to offshore the manufacturing and supply chain for many companies based in the U.S. and Europe. I think there’s certainly incentives to accelerate the onshoring or nearshoring, and that will happen likely at a faster pace than the offshoring trend did, but these are still measured in periods of many years, if not even a couple of decades.

So, I think what’s exciting about it is, from a fundamental investor standpoint, is being able to discern who the advantaged companies might be. Justin hit upon a number of areas in his answer, but I’d also add companies that are able to help consult on businesses that are looking to bring manufacturing back towards the United States, companies involved in automation … Because I totally agree with what Justin said about the inflationary impacts on wages and the worker shortage that we have.

But then a lot of critical industries that have been identified by the government to really support – and he certainly hit on the semiconductor space and its importance in the automotive industry – things like manufacturing for healthcare products and pharmaceuticals that were maybe more exposed when there were shutdowns around the globe for COVID that put some of those supply chains at risk. So I think there are a lot of really intriguing opportunities to think about that fundamental investors can discern as we dig deeper.

Hetts: This has been a great conversation. I think to close it out, let’s save the elephant in the room for the end here. We’ve had this long-running underperformance of small caps versus large caps in the U.S. So if you try to put this whole conversation together, can you two lay out why you’re optimistic that small cap can switch that regime and start outperforming large cap?

Coleman: Yes. We remain optimistic, Adam, that small cap will have its day in the sun. These things tend to go in long cycles. In fact, if you go back over the last 60, 70, 80 years, there tends to be periods of alternating outperformance between large and small caps that usually last between seven and 10 years. We think we’re in the very late stages of an extended period of large cap outperformance that has lasted actually longer than some of those periods, 11 to 12 years now. There are a couple of building blocks of previous examples of regime changes wherein small caps started to outperform large caps that are evident again today, and I would highlight two.

One of those is that when there’s a lot of crowding at the top of the market in the large-cap space, that tends to signal a regime shift toward small cap. Specifically, that’s when the top five companies in the S&P 500 achieve a greater than 20% weight in the index, and we’re there now. In simple terms, I would say that when that has happened in the past, there’s such crowding in these very large market caps that the pool of incremental buyers ultimately ends up getting exhausted, and they collapse upon themselves, and they can’t sustain the momentum that they have. So that has signaled regime shifts in the past and we’re back there today.

Then another building block of potential regime change would be looking at the relative price-to-book ratios of the large-cap universe versus the small-cap universe. That has tended to peak at about 230% or 240% relative price-to-book ratio of large caps versus small. We’re there now, and that has resulted in a period of small caps outperforming for an extended period of time, and that usually bottoms at about 130% price-to-book ratio. So, we think that, again that is setting up for potentially a period of an extended run of small cap outperformance. So I remain optimistic about that.

Tugman: I would echo everything that Jonathan said. I think when you look at the valuations, particularly versus large cap, we’re seeing some pretty significant disconnects that would take you back to levels … for instance, if we look back at the valuation discount, it’s now bigger, small versus large, than at the start of the 1999 to 2011 leadership period for small caps.

I would also say that, to go back to one of the points Jonathan made about the crowding at the large end, and names like Apple being bigger than the entire small-cap benchmark, it doesn’t take a lot of money to come out of a name like Apple and be redeployed into small caps to see some pretty significant moves when you start to see the money begin to flow out of large caps into small.

I think the final thing I would highlight is that if you look at the market cap as a percentage of the U.S. equity market, small caps right now are about 4.2%. If you go back to 1930, it has averaged 7.5%. So I think when we get to those type of extreme levels, it is tough to tell the exact timing, but I agree that we are setting up for a very nice period of potential long-term outperformance by small caps.

Hetts: Thank you. A lot of great data there, the extent of the dispersion that we’re going through between small and large. So, guys, I think that wraps us up. Thank you for doing this and for that tour of the small-cap space and the opportunities there. Anything we’ve missed that we should cover before we close out?

Coleman: I think we’ve covered a lot of ground. We appreciate the opportunity to talk about why we think small caps are attractive.

Tugman: Yes. Thank you very much, Adam and Jonathan.

Hetts: And a thanks to our listeners for joining. If you haven’t already, you can find more Global Perspectives on Spotify or iTunes or wherever you listen. And, of course, check out the Insights section of the Janus Henderson website for more of our views. Thanks again and we’ll see you next time.