Could smaller companies have a bright spot despite a gloomy environment?

Schroders answers the question, "Are small cap stocks too risky in tough economic conditions?".

Nkosi Kondi, Country Head - South Africa, Schroders
Nkosi Kondi, Country Head - South Africa, Schroders

Investing in smaller capitalisation (small cap) stocks when economic conditions are tough can feel uncomfortable. Yet, history tells us that this can be a good time to start considering whether these companies deserve a place within a diversified portfolio. We analysed data from the past five decades to get some insights from history to test this thought.

The stock market gazes into the crystal ball

One of the best leading indicators is the stock market itself. This is because investors are not only concerned with today’s headlines but also how the future will unfold. Investors anticipate how the future might unfold and then transact in company shares accordingly, driving the share price up or down in advance of actual news. This means – for example – when a company announces how much it has grown its sales, the share price might not change on that day if the company grew by the amount that investors expected.  

What tends to send the share price moving on the day is when the announcement is above or below what was expected. Small-cap stocks are no different in this way, and this can be a clue to guide us to what may be in store for their future.

What the market expects

Over the past year, the fortunes of large and small companies worldwide have diverged. This was primarily driven by the largest, so-called magnificent seven companies in the US, but also reflects the risks associated with owning smaller companies, which are more sensitive to the economic cycle.

One-year cumulative return for global large vs small companies (USD)

Larg Cap versus small cap stocks
Past performance is not a guide to future performance and may not be repeated. The value of investments and the income from them may go down as well as up and investors may not get back the amounts originally invested.

Investors may favour larger companies in the late phase of an investment cycle for a few reasons. Larger companies have multiple research analysts interpreting their performance which reduces uncertainty, they have easier access to finance in times of need and multiple diversified products to sell which helps stabilise their cash flows. This makes larger companies an attractive offering going into an economic slowdown. But as the above performance chart shows, this may have already been acknowledged by the market. The key question is whether small-cap stocks may have enough “bad expectations” in their price; we could look to history to guide us.

The key question is whether small cap stocks may have enough “bad expectations” in their price.

What does the long-term evidence show?

We have crunched the data going back to 1980 to find out. We studied how large and small-cap share prices behave during each phase of the investment cycle. The table below shows that investing in small caps when the environment feels uncomfortable has generated good results when investors take a long-term approach.

Average monthly return in US dollars (%)

Phase of economic cycleSmall capsLarge caps
Recession and recovery1.80%0.85%
Expansion and slowdown1.13%1.10%%
Source: Schroders as of October 2023. Past performance is not a guide to future performance and may not be repeated.

While the average returns from small-cap and large-cap stocks in the expansion and slowdown phases have been similar over this period, small-cap stocks have – on average – delivered more than double the returns from large caps through both the recession and recovery phases. However, no two cycles are exactly alike, and the current cycle may provide its own clues as to what may lie in store for investors.

Positioning for the next phase in the economic cycle

While it’s always challenging to identify the exact turning points in any economic cycle, we are starting to see some evidence building that we are closer to a turning point than we have been in the past. Our study provides evidence that you tend to get rewarded for looking ahead to when smaller companies will do well again.

We are starting to find some attractive opportunities among small caps, particularly in regions that have already experienced the pain of higher interest rates. When markets recognise that a new phase in the investment cycle has begun, stock prices will often change sharply and suddenly. While it’s important to be mindful that investment performance can be hit by increasing the allocation to smaller companies too early, it’s prudent to ensure you have a seat at the table to avoid missing out on small-cap performance, which often arrives suddenly.

We selectively allocate to smaller companies across our investment solutions, with a keen eye on risk management. The focus is on the regions offering the best valuation opportunities, and selecting fund managers who are well-equipped to navigate any tough conditions ahead to implement this exposure.

Important Information

For professional investors and advisers only. The material is not suitable for retail clients. We define “Professional Investors” as those who have the appropriate expertise and knowledge e.g. asset managers, distributors and financial intermediaries. Any reference to sectors/countries/stocks/securities are for illustrative purposes only and not a recommendation to buy or sell any financial instrument/securities or adopt any investment strategy. Reliance should not be placed on any views or information in the material when taking individual investment and/or strategic decisions. Past Performance is not a guide to future performance and may not be repeated. The value of investments and the income from them may go down as well as up and investors may not get back the amounts originally invested. Exchange rate changes may cause the value of investments to fall as well as rise. The views and opinions contained herein are those of the individuals to whom they are attributed and may not necessarily represent views expressed or reflected in other Schroders communications, strategies or funds. Information herein is believed to be reliable but Schroders does not warrant its completeness or accuracy.Issued in January 2024 by Schroders Investment Management Ltd registration number: 01893220 (Incorporated in England and Wales) which is authorised and regulated in the UK by the Financial Conduct Authority and an authorised financial services provider in South Africa FSP No: 48998

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