First thing first, when we talk about small-cap equities (or small caps), it’s important to understand what “cap” refers to. Cap is short for capitalisation, which in turn is short for market capitalisation. The market capitalisation of a company is the total dollar value of all the outstanding shares of that company – essentially, how much the company is worth. Small caps are not tiny companies at an early stage of development. They’re companies with market capitalisation of $250 million and $2 billion. So, these are still big businesses, they’re just not worth tens or hundreds of billions (let alone trillions).
Ultimately, the main reason for investing in small caps is that they have more room to grow, simply because their market cap is smaller. In theory, it’s quicker to grow from $1 billion to $2 billion than it is to grow from $1 trillion to $2 trillion. However, due to their size, small caps are higher risk than their large-cap counterparts. Small-caps tend to be more volatile than larger companies as they have less capital and resources, making them more sensitive to market changes.
Today, we believe a good reason for holding small caps is that they do relatively well when the economy is picking up momentum and positively surprises expectations. In particular, when the economy is surprisingly strong, the improvement in small-cap earnings tends to be more pronounced compared to large caps. While slowing from the breakneck pace of the past couple of quarters, the solidity of US domestic demand and job growth is positive for small caps. They are also typically more sensitive to higher interest rates, so as interest rates fall, which is likely to happen sooner in the Eurozone than in other developed regions, small caps could benefit.
Valuations are different to market capitalisation. Rather than the absolute dollar value of a company’s shares, valuation is more nuanced. It seeks to determine the ‘fair value’ of an asset, in this case an equity, and there are many different ways to do it. Broadly, if an equity is undervalued, that means it’s attractively valued; if it’s overvalued, that means it’s expensive. Historically, investors paid a premium for small-cap equities versus large caps due to the growth potential, but that is not the case today. In terms of valuations, in the US, the Russell 2000 – an index of smaller companies – is trading at a significant discount to the Russell 1000 (representing larger companies). Therefore, the Russell 2000 is relatively cheap compared to the Russell 1000. It’s the same in the Eurozone. The relative valuations of small caps there is quite low, suggesting a big discount.
We currently hold more global small caps than usual relative to our long-term asset allocation. However, in absolute terms, our biggest equity exposure is in large-cap US equities. For large caps in the US, valuations are somewhat demanding in the near term, but growth prospects are strong at more extended horizons. Small caps valuations, on the other hand, are still at 15-year lows relative to the MSCI World equity index, which seems compelling given the improving US economic outlook. Unlike large caps, their prices reflect a much more negative growth backdrop vs our base case. As the European economy remains weak and given the proximity of the region to a variety of geopolitical risks, we keep a slightly reduced exposure to Europe ex UK equities, even though valuations are around average levels.
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