Are Small Cap Stocks Further Along the Road to Recovery?

 

Small-cap companies are usually the most vulnerable to volatility, with their stock prices and earnings getting hit particularly hard and early in economic downturns, much like what occurred in 2022. Yet they also tend to lead the way on both fronts during recoveries. 

In fact, after significantly underperforming their large-cap peers over the last few years, small-cap valuations have become more compelling. And recent earnings forecasts are adding to their recovery potential.  

Earnings forecasts reveal an interesting discrepancy between larger and smaller stocks. Consensus 2023 earnings-per-share (EPS) estimates for US small-caps dropped 15.9% from January 1 through November 30, 2022, versus just 5.4% for large-cap estimates (Display). 

Further out, preliminary earnings forecast revisions for 2024 have trended much more positive for small-caps (0.3%), while still trending sharply downward for large companies (–7.5%). We think the greater drop in near-term earnings estimates suggests that expectations may already be factoring in more challenges from a potential recession. While estimates further out are harder to have confidence in, they suggest that small-caps can offer greater upside as the economy gradually recovers. 

Valuation Gap Looks Extreme

Meanwhile, small-cap stocks are also trading at extremely depressed valuations—the lowest in 20 years—compared to larger companies, based on price-to-earnings ratios. Current geopolitical tensions and macroeconomic uncertainties have disproportionately and indiscriminately impacted small companies. Investors have discounted further potential hazards for small-caps, without regard to company fundamentals. So, we think firms that offer resilient business models will stand out and benefit the most along the road to recovery. 

Small-cap stocks are commonly seen as riskier than other asset classes. But their relatively higher volatility can create opportunity, too. We believe that companies that combine attractive valuations and high-quality features such as strong management teams, good business models and solid balance sheets can best navigate the uncertain future.  

So, even if there’s more macro pain and market volatility ahead, smaller stocks might be further along the route to recovery. We think small-cap valuations and forward estimates reflect investors having discounted many of the hazards ahead—perhaps more so than for large-caps. Investors who have been underweight small-caps in their allocations might want to consider re-positioning toward portfolios of small or mid-size companies that offer resilient business models currently trading well below their long-term potential.