Analysis: Global small-cap stocks lure bargain hunters after sluggish 2023
07/12/2023 12:52
(Repeats earlier story to widen distribution, no change to
content of story)
By Samuel Indyk and Lewis Krauskopf
LONDON/NEW YORK, Dec 7 (Reuters) - Shares of smaller
companies that have lagged for most of 2023 are drawing
investors on both sides of the Atlantic, as they weigh the
benefits from an expected fall in interest rates next year
against worries about a possible economic downturn.
In the U.S., the small-cap Russell 2000 .RUT has jumped
over 13% from its October lows, while the MSCI Europe Small and
Mid Cap Index .MIEU000D0PEU is up 12% since late last month.
The recent surge in small caps stands in contrast to
much of the year. While the S&P 500 .SPX is up 19%
year-to-date, the Russell 2000 has climbed just 5%. Europe's
small caps, meanwhile, have risen over 6% in 2023, versus a 12%
increase in the broader MSCI Europe equity index
.MIEU00000PUS .
That underperformance has helped make small caps look
cheaper than their larger peers when compared to their
historical valuations.
U.S. small caps are near their lowest-ever relative values
to large caps, according to LSEG Datastream. The small-cap S&P
600 .SPCY trades at 13.7 times forward earnings against its
long-term average of 18 and well below the S&P 500's current
level of 19.
European small caps trade at a forward price-to-earnings
ratio of 12.2, below the 15-year average of 15 and below the
broader MSCI Europe's current P/E of 12.3.
"We're approaching 2-1/2 years of relative underperformance
and if you look at the valuation multiples of small caps now,
they're very, very cheap," said Rory Stokes, portfolio manager
on the European equities team at Janus Henderson.
Those valuations have boosted the appeal of small caps in a
multi-asset rally sparked by bets central banks globally will
begin cutting rates in 2024 if inflation keeps falling. Recent
data has shown U.S., European and British consumer prices
cooling more than forecast.
Markets are pricing in over 125 basis points of rate cuts
each by the Federal Reserve and European Central Bank next year
following a hiking cycle that has lifted borrowing costs to
their highest in decades, while benchmark government bond yields
also have dropped.
That is good news for small caps, investors said.
Elevated borrowing costs can be more damaging to smaller
companies, which tend to be more reliant on shorter-term debt
that is now being financed at higher costs after years of
rock-bottom interest rates.
The recent fall in Treasury yields "loosened the noose"
around many small-cap companies, said Jack Ablin, chief
investment officer at Cresset Capital.
U.S. small caps have outperformed large ones during periods
of increasing growth and slowing inflation, with the Russell
2000 up an 25.2% on an annualized basis versus 17.3% for the S&P
500, a Morningstar Wealth analysis of data since the 1970s
showed.
The firm is overweight small-caps in its U.S. equity fund,
as cheap valuations give the stocks "some margin of safety,"
said Marta Norton, Morningstar Wealth's chief investment officer
in the Americas. "That valuation opportunity has just expanded
relative to large cap."
Small-cap earnings also are expected to pick up. Russell
2000 companies' earnings are forecast to increase about 30% next
year after falling 11.5% in 2023, LSEG data showed.
"Small caps will snap back quickly and the recovery will
be strongest in the early part," said Amisha Chohan, head of
small cap strategy at Quilter Cheviot. "It is important to have
some exposure to this area of the market, especially given where
valuations sit."
Recent small-cap stock winners include wireless audio
company Sonos SONO.O , which has jumped over 40% in the past
month, while Victoria's Secret & Co VSCO.N has gained 33%
during that period, and Britain's Hotel Chocolat HOTC.L soared
after the company agreed earlier this month to a takeover offer
from confectionary giant Mars Inc.
Reasons for caution remain. While hopes of a so-called
economic soft landing have supported stocks, some investors
worry the rate hikes will bring a recession in 2024.
That would likely hurt small caps, which tend to suffer
disproportionately in downturns. Since 1980, the Russell 2000
has lagged the S&P 500 by an average of about four percentage
points in the six months after the economic cycle has peaked,
ahead of a recession, data from Strategas showed.
"There is a legitimate case to be made that the economy
could struggle sometime in the next 12 to 18 months," said
Bryant VanCronkhite, senior portfolio manager at Allspring
Global Investments. "If that's the case, the valuations we see
today are probably not going to support small caps."
Mabrouk Chetouane, Natixis IM's head of global market
strategy, believes that thinning year-end trading, recession
worries and central banks' insistence that it is too early to
consider cutting rates argue for avoiding small caps.
"If we have a negative shock, then volatility will be more
elevated in segments of the market where liquidity is weak,"
Chetouane said. "From a tactical point of view, it's not the
time to buy or add small caps."
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Large cap stocks vs small cap stocks https://tmsnrt.rs/3T67QKK
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(Reporting by Lewis Krauskopf and Samuel Indyk; Editing by Ira
Iosebashvili and Richard Chang)
((Ira.Iosebashvili@thomsonreuters.com;))