Small but mighty:
Harnessing the power
of small cap stocks
March 2024
The “Magnificent Seven” reasons why small cap stocks offer a timely
and unique investment opportunity.
§ Compelling investment diversification.
§ Attractive valuation relative to large cap stocks.
§ Investor neglect creates high alpha generation opportunities.
Murphy O’Flaherty
Portfolio Manager § Mathematics of growth.
& Senior Equity Analyst, § Beneficiaries of falling interest rates.
RBC Enterprise Team
§ More U.S.-centric in operations and end markets.
§ R
ecent underperformance creates attractive entry point for this superior
long-term performance asset class.
Introduction
U.S. small cap stocks often get “no respect” from investors. This is remarkable, because
as an asset class, they have provided compelling long-term performance compared to
Lance James U.S. large cap stocks and returns well above investment grade bonds and cash.
Lead Portfolio Manager,
RBC Enterprise Team
Exhibit 1: Compelling long-term results annualized returns 1999-2024
9.0
8.29
“Small cap 8.0
7.82
stocks possess
25 year annualized returns
7.0
6.0
intrinsic 5.0
characteristics 4.0
3.82
that should 3.0
1.76
2.0
be attractive 1.0
to long-term 0
Russell 2000 S&P 500 Bloomberg U.S. ICE BofA U.S. 1 month
investors.” Agg Bond Treasury Bill
Source: Morningstar Direct.
Small cap stocks possess intrinsic characteristics that should be attractive to long-term
investors, and there are important near-term catalysts that make them timely investments in
the current market environment. Let’s dig deeper to fully appreciate what’s going on here.
1
Small but mighty: Harnessing the power of small cap stocks
Diversification Attractive Valuation
Adding small cap stocks to an investment portfolio offers Following an extended period of outperformance by
diversification not only from large cap companies but large cap equities, fueled most recently by the so-called
also from the concentration currently found in the S&P “Magnificent Seven,” small cap stocks are trading near
500 index. Today, greater than 24% of the S&P 500 index multi-decade low valuations compared to large cap
is dominated by just five mega-cap stocks. In contrast, stocks. Comparing profitable companies in the small cap
the top five stocks in the Russell 2000 index account for not Russell 2000 to money-making corporations in the large
quite 4% of that index, as measured by weight. cap S&P 500, small cap stocks trade at a steep discount
on price to trailing twelve months earnings. In fact, over
the last 50 years, there have been only two periods of such
Exhibit 2: Top five holdings steep discounts: in 2000, just before the dot-com bubble
crash, and in 1973 preceding the crash of the “Nifty Fifty.”
S&P 500 Russell 2000 The recent run-up of the “Magnificent Seven” may
provide the framework for a similar recovery in small cap
Microsoft 7.1 Super Micro Computer 1.9
valuation multiples.
Apple 5.8 MicroStrategy 0.7
NVIDIA 5.2 Comfort Systems USA 0.4 “The recent run-up of the “Magnificent
Amazon 3.7 e.l.f. Beauty 0.4 Seven” may provide the framework
Meta 2.6 Light & Wonder 0.4
for a similar recovery in small cap
valuation multiples.”
24.4 3.8
According to Morningstar, at the end of 2023, the average
Source: S&P Global, FTSE Russell, as of March 12, 2024. P/E ratio for the Russell 2000 stocks was 16x, well below its
average for the past decade and cheap compared to the
In recent years, the Russell 2000 index has seen broader 22x P/E ratio for the large cap Russell 1000. Small caps trade
participation in constituent gains than has the S&P 500. at a steep discount on this measure despite producing higher
In addition, publicly traded small cap equity portfolios long-term earnings growth. Further, the average price-to-book
provide exposure to companies of a size often associated ratio valuation for small caps at year-end 2023 was barely
with private equity investing, but offer greater liquidity, over half that of large cap stocks. On numerous valuation
typically lower fees and superior visibility on company measures, small caps are historically undervalued compared
fundamentals and valuation. to their large cap counterparts.
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Small but mighty: Harnessing the power of small cap stocks
Value-Added Active Management
Institutional neglect creates the potential for significant The proof is in the results. Active small cap managers,
alpha generation from intensive fundamental research on average, have historically outperformed their
and active management of small cap stocks. Analysts from respective benchmarks more consistently than other
sell-side brokerage firms increasingly avoid covering small equity classes. As an example, examining Morningstar’s
cap companies unless there is specific investment banking Small Blend category as a proxy for active management,
potential because the trading activity in many of these the category average beat the Russell 2000 for the 3, 5,
stocks cannot justify the cost of coverage. Many buy-side and 10-year periods ended February 29, 2024. 87% of funds
institutional portfolio managers similarly avoid small beat it for the 3-year period, 72% did so for the five-year
cap stocks because a) their benchmarks don’t include period, and 59% of funds beat it for the 10-year period,
small caps, b) trading liquidity is a greater challenge, net of fees.
and c) research must be generated in-house.
“Active small cap managers,
Comparative lack of sell-side analyst coverage and on average, have historically
overall buy-side institutional neglect of small cap stocks
outperformed their respective
create information gaps and pricing inefficiencies that can
be capitalized upon by investors committed to intensive benchmarks more consistently
fundamental research and active management. than other equity classes.”
Exhibit 3: Peer Group returns net of fees
03.01.21 - 02.29.24 03.01.19 - 02.29.24 03.01.14 - 02.29.24
3 year Return Peer Group 5 year Return Peer Group 10 year Return Peer Group
Group/Investment (Annualized) percentile (Annualized) percentile (Annualized) percentile
Russell 2000 Total Return Index -0.94 87 6.89 72 7.13 59
U.S. Small Cap Core Peer Group Median 2.87 7.95 7.45
Source: Morningstar Direct, as of February 29, 2024.
Mathematics of Growth Interest Rate Sensitivity
We believe that over the long-run, a company’s stock While our investment approach to small company investing
valuation is directly related to the amount of earnings emphasizes solid balance sheets and attractive cash flows,
and cash flow it can generate for shareholders. The in general, small companies employ significantly more
valuation multiple at which a company’s stock trades financial leverage than large companies. They also tend to
is typically closely related to the rates at which it can be more reliant on outside financing to support and grow
sustainably grow sales, earnings, and cash flow. their businesses. According to data from Russell Investments,
as of December 31, 2023, Russell 2000 companies had a net-
From a purely mathematical perspective, it is simply easier debt-to-EBITDA (earnings before interest, taxes, depreciation,
for less mature small cap companies to grow these key and amortization) ratio of 3.2x, compared to an average
financial metrics at faster rates than large and mega-cap of 1.6x for the S&P 500. This higher level of financial leverage
companies. Just as babies increase their height and weight heightens the importance of debt servicing and the level
at far faster rates than juveniles and certainly adults, less of interest rates for small cap companies.
mature companies with successful business plans and able
management teams can grow faster than established large When the Federal Reserve began its persistent program
cap companies. A small company that is successful locally of raising interest rates to combat inflation in 2022-2023,
can expand regionally, then nationally, and finally, globally. the period was marked by sizable underperformance of
Each expansion accelerates growth in a manner that is greater debt-burdened small cap companies compared
unavailable to the established global large cap company. to large caps. A subsequent easing in rates should
For most large cap companies, success is measured by inflation subside should disproportionately benefit
growing at rates slightly greater than GDP rate of growth. small cap stocks.
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Small but mighty: Harnessing the power of small cap stocks
U.S.-centric Attractive Entry Point
Domestic small cap companies tend to have a much The best time to increase weighting in a long-term
greater portion of their operations and end markets in the outperforming asset class is after a sustained period
United States compared to large cap companies. Currently, of underperformance, and when both fundamental and
the U.S. economy is an envy of the world in terms of valuation characteristics are favorable. While U.S. small
growth, stability, and the rule of law. For broad-based cap stocks have had a sizable performance advantage
consumption expenditures, there are few markets to rival over large cap stocks over the past century and even
the United States. since the year 2000, the past decade has witnessed the
dominance of large cap returns.
“Domestic small cap companies tend
to have a much greater portion of Sales and earnings are projected to grow at a faster rate
for the small cap Russell 2000 in 2024 than for the large
their operations and end markets cap S&P 500. According to Zacks Investment Research,
in the United States compared to large The Russell’s year-over-year earnings are expected to
cap companies.” grow a healthy 10% in 2024 and a robust 41% in 2025! This
compares to 8.4% for the S&P 500 in 2024 and 25% in 2025.
Furthermore, domestic small cap companies should Of course, these are estimates, but this improvement
disproportionately benefit from the efforts to “re-shore” in fundamentals combined with the historically low
supply chains and many are beneficiaries of the relative valuations of small cap stocks compared to large
infrastructure spending bills. Finally, foreign currency caps referenced above could be a trigger for change in
fluctuations typically have less impact on domestic market leadership.
companies.
Final thoughts
Adding small cap stocks to an investment portfolio offers diversification not only from large cap companies and the
concentration currently found in the S&P 500 index, but also from alternative investments including private equity.
U.S. small cap stocks currently offer a timely opportunity to gain exposure to an asset class that has historically provided
superior long-term investment performance at attractive valuation levels. Intensive fundamental research and active
portfolio management have consistently produced superior returns in this already high-performing asset class.
About Small Cap Equities at RBC GAM
The Enterprise Small Cap team, based in Boston, MA, manages a range of micro and small cap core and value equity strategies.
The portfolio management team averages over 30 years of investment experience. The team focuses on identifying companies that
exhibit strong business fundamentals trading at low valuations.
The Small Cap Growth team, based in Chicago, IL, manage small and SMID cap growth strategies. The highly experienced investment
team focuses on buying high quality, profitable companies and holding them over the long term. This prudent approach to growth
investing has yielded portfolios that tend to exhibit low volatility.
4
Small but mighty: Harnessing the power of small cap stocks
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