2023 was the year of the giants. Much of the S&P 500’s 24% advance in 2023 was due to just a handful of top stocks. The FANGS+ index, which tracks the performance of the top 10 most traded US technology firms, including the likes of Microsoft and AI chipmaker Nvidia, gained 96%. In contrast, a measure of the S&P 500, which dilutes the impact of these titans by allocating a 0.2% weighting to each company in the index regardless of size, rose slightly less than 12% in 2023.
The Russell 2000, America’s leading index for small cap companies with valuations ranging from as little as $50m to around $10bn, did slightly better at 15%. But it is notable that over the past five years, the gap between the biggest and smallest companies has been even wider, with the Russell 2000 up just 35% compared to 84% for the large cap S&P 500 and a 255% surge in the giant tech FANG+ index. (All figures are taken as of 15 January 2024.)
Time to shine?
After this long period of underperformance, finance chiefs at more modestly sized enterprises will be wondering if 2024 will be a year in which their stocks can shine. This would make it easier to raise capital for expansion as confidence grows that the US economy will avoid a painful recession.
The odds look good that earnings at smaller caps will be getting a boost this year
A range of smaller companies made their debut on the stock market in 2023, with nearly 70% of initial public offerings raising less than $25m, according to EY’s Global IPO Trends publication. That compares to an average of around 10% over the prior decade.
So, can smaller caps outpace their larger peers over the coming year? There are several grounds for optimism.
First, smaller companies tend to benefit more than the titans from lower borrowing costs when central banks ease monetary policy. Analysis by UBS shows that close to half the debt of companies in the Russell 2000 index was floating rate. That compares to around a 10th for large companies.
This makes sense. Small-cap companies typically rely more on bank lending than capital markets. And given that investors view most small caps as a riskier proposition, they steer these companies toward issuing shorter-duration bonds when they do access capital markets. While this duration mix is often a headwind for small caps, especially when central banks are pushing up interest rates as in 2022, it should prove a boon in 2024.
Rate cut uncertainty
Of course, it is not certain when – or even if – the Federal Reserve will cut rates in 2024. But it looks highly likely that rates will fall significantly this year. The median forecast of top Fed officials is for three 25-basis point rate cuts in 2024. Investors are even more optimistic, pricing a high level of confidence that there will be at least five rate cuts, most likely starting in March. Either way, the odds look good that earnings at smaller caps will be getting a boost this year as serving debt becomes cheaper.
Around a third of the companies on the Russell 2000 have a red bottom line
Second, lower interest rates should help the valuations of small-cap companies, which lag badly after years of underperformance relative to the main index. This is especially the case for the many less profitable – or unprofitable – early-stage companies. For example, the Russell 2000 hosts plenty of start-up biotech firms that have yet to turn a profit.
Overall, around a third of the companies on the index have a red bottom line. Such companies face a stronger headwind on markets when interest rates are higher. Since much of their valuation relies on the hope of profits years in the future, a higher interest rate lowers their net present value in discounted cashflow models.
Unsustainable gap
Even for companies with earnings, the valuation gap between the largest and the smallest company in the US now looks unsustainably wide, according to UBS. The price-to-earnings ratio of the S&P 600, another index that gauges the performance of smaller companies, trades at 13.6 times the consensus forecast for the coming 12 months, a 30% discount to the S&P 500, as of mid-January.
While some discount is usual, this price-to-earnings multiple is also well below the small-cap average of 17 times over the past decade. On a price-to-book basis, the discount also looks excessive compared to recent history. As of 12 January, the Russell 2000 was trading at a near 55% discount to the top 1,000 companies in the US, far more than the 32% discount over the past 10 years.
Trump card
That said, the giants have a potential trump card up their sleeves too. The growing trend towards commercialising generative artificial intelligence is set to remain a major source of excitement for investors. While this looks likely to benefit companies of various sizes, the formidable cost of development could ensure that the bulk of the gains continue to accrue to businesses able to allocate billions to research and development.
AI will surely boost productivity for many small caps, but the bulk of the gains look likely to go to the providers
A CNBC survey taken at the end of 2023 found that 55% of companies planned to buy enterprise-level generative AI software, such as Microsoft Copilot, in the next six months. Although this will surely boost productivity for many small caps, the bulk of the gains look likely to go to the providers themselves. Analysts are now expecting Microsoft’s revenues from generative AI to reach as high as $10bn annually over the next three years.
However, despite this advantage for the mega-cap technology firms, 2024 is shaping up to be a positive year for small-cap companies. And, if one excludes the tech sector in particular, a period of catchup for small cap versus large cap looks highly likely.
