Investors should be wary of US small-cap stocks

The writer is a former chief investment officer at Bridgewater Associates

There is an old market adage that low valuations are a “necessary but insufficient” condition when looking to buy securities. That feels especially true for smaller listed companies in the US today.

Several metrics suggest valuations of smaller US companies are increasingly attractive for buyers, especially compared with stocks that have larger market capitalisations.

From the latest respective peaks, the Russell 2000 benchmark for smaller caps has lost about 26 per cent, twice as much as the S&P 500 through late April. Meanwhile, the 12-month trailing price/earnings ratio for the Russell 2000 has dropped from pre-pandemic levels around 19.5 to 12.5 (excluding lossmaking companies as the benchmark includes many young companies yet to make a profit). That compares with the S&P 500’s similar trailing p/e of 21.2, which is down only a touch from a pre-pandemic 22, according to Bloomberg data.

This notable valuation discount isn’t likely to be enough to see the Russell 2000 outperforming on a sustained basis anytime soon. Of course, there will be stockpicking opportunities as some select small-cap securities show relative strength. However, the broader small-cap index will be challenged in absolute terms and in comparison with large-cap peers by at least two factors: disappointment on the prospects for monetary policy easing by the Federal Reserve and fallout from the recent banking turmoil.

Stock prices today reflect consensus expectations of a 0.25 percentage point rise in rates by the Federal Reserve and then a pause before a rapid pivot to sustained easing later this summer. While possible, easing that quickly and forcefully seems unlikely without a financial shock that supersedes inflation as a Fed priority, or an unexpected collapse in inflation. The latter almost certainly would require a fast deceleration in growth.

In either scenario, there would be rapid repricing of earnings expectations, with a potential flight to safety apt to weigh on stocks but especially on less-liquid small-cap stocks. More likely in the coming months is the picture the Fed has repeatedly tried to paint — one of a coming pause alongside an inflation focus that could allow for more hikes, depending on evolving conditions.

A lot would have to change very quickly to get Fed policy aligned with current short-term interest rate expectations. Economic growth today is still running at about 2.5 per cent, according to Atlanta Federal Reserve estimates for the first quarter. Wage growth, a key inflation component, is holding between 4-6 per cent depending on how it’s measured.

Debt dynamics are a key reason that higher-for-longer borrowing costs should have an outsized impact on small-cap companies. Not only do US small-caps today have substantial debts but they also have a notable portion of total burden that is susceptible to sustained, higher borrowing costs. JPMorgan estimates that more than 37 per cent of total debt has floating interest rates for US and Canadian small and mid-cap companies, compared with 15 per cent of large-caps. Small-cap companies’ debt also has shorter average maturities than large cap, at 5.7 years versus 8.2 years.

If the Fed does not ease aggressively and quickly as interest rate markets currently discount, many small companies will be at risk — they will need to refinance sooner and at higher rates than their large-cap peers.

The monetary policy challenges for small caps are compounded by fallout from the recent banking turmoil. At least in the US, small companies rely more heavily on bank credit; larger ones have more varied financing sources.

Even trickier today, small US companies tend to frequently use small banks — the latter often more willing and able to evaluate risks and extend credit to their local enterprises. A recent research note by Goldman Sachs estimated that small US companies receive nearly 70 per cent of commercial and industrial loans from banks with less than $250bn in assets.

As more local and regional banks position to navigate potentially greater regulation and deposit outflows as well as a slower economy, the availability of needed capital for small-cap companies is at risk of shrinking. Such a change was already starting to surface in the latest National Federation of Independent Business (NFIB) small-business survey last month.

History suggests it is best to consider indices such as the Russell 2000 when the market bottoms, as smaller companies often lead the way higher when an economic cycle turns. Unfortunately, current conditions do not yet seem sufficient for a winning investment.