Long after the discovery of the Fama French HML factor, smallcaps have continued to outperform in recent times. As an investor with a smallcap bias, it is worth checking whether the environment supports the continuation of this trend.
The main question, are smallcaps too expensive?
UBS recently published a smallcap strategy note with some helpful data points. First, 2015E PE seems reasonable, but as always with smallcaps, this largely depends on whether growth can be maintained given the current challenging European environment.
It is very easy to overpay for growth especially in blue-sky smallcaps, the kinds that will get severely beaten down in a market correction.
Are earnings level artificially high?
A comparison of EBIT margins versus other cap segments suggests that margins have actually fallen from their peaks.
Smallcap results have recently been in line with expectations, indicating that perhaps analyst valuations have already and will continue to incorporate a modest outlook.
Are macro conditions affecting the prospects for smallcaps growth?
An earlier comprehensive 2013 UBS report finds that the key driver for long term outperformance in smallcaps is core sales and earnings growth.
Between 2003 and 2013, smallcaps grew sales at 7.3% CAGR and EPS at 23.2% CAGR, which is far better than largecaps at 6.2% CAGR sales growth and EPS at 14.9% CAGR. This superior earnings growth explains the lack of valuation premium despite long sustained outperformance.
More recently however, the 2014 report describes a bleaker picture:
European equities have seen 42 months in a row of earnings downgrades. For 3½ years analysts have been downgrading their European earnings forecasts (Japan managed 51 months in the early 1990s). If it has felt relentless, that’s because on average we have had nearly 100 downgrades every single working day since March 2011. Clearly the macro recovery post crisis in Europe has been significantly weaker than in the US. After the financial crisis, Europe fell almost straight into the Eurozone debt crisis.Finally, as PMIs in Europe turned up in a synchronised fashion in mid-2013, companies then faced the headwind of a strong euro dragging on earnings.
Looking ahead though, UBS see some upside from QE by the ECB. A 10% depreciation in Euro may lead to a 6% boost to European earnings, given that 47% of sales are overseas.
I am hopeful of this and will look for quality companies that will benefit from such a move.
How would smallcaps perform in a bear market?
A bear market does not necessarily mean smallcap underperformance. The plot below shows the average relative performance of small/midcaps to largecaps during six bear markets.
Much of the previous outcomes were related to starting valuation levels and relative sector exposures (e.g. high financials weight in largecaps). As a consequence, risk appetite may not be the major driver.
It is therefore a mistake to dismiss smallcaps as a potential hunting ground during bear markets. In fact, the opportunities are more clearly marked and quality companies rise like flotsam, making them easier to identify. In addition, blunt de-risking by big funds during corrections (analogous to throwing jetsam to lighten the ship) throws up a lot of opportunities to obtain quality companies at a discount.
M&A also provides support even in bear markets. While deal volumes and mega deals may be down, smallcap bolt-on acquisitions tend to continue. In fact, a low growth world and high corporate cash levels promote this.
What is the effect of interest rates on smallcaps relative to largecaps?
Borrowing data from the US market, this chart shows that following a rates rise, the Russell 2000 outperformed against the S&P 500. According to the 2013 report, this may be because historically, smallcaps have always enjoyed lower financial leverage. (Largecaps are more exposed to the utility sector, for instance).
With the low interest rate environment likely to persist for a while in Europe, this is likely to be a non-issue, as long as peripheral spreads don’t widen too much.
The take away from both reports is that there are great opportunities within smallcaps even in the current environment.
Once earnings momentum has recovered, smallcaps grow more quickly than their largecaps counterparts, a point to remember if investing for the long term.