Capital Ideas^TM

Over the last couple of years, the gap in both returns and valuations between small-cap and large-cap stocks has expanded against the backdrop of tighter monetary policy, higher interest rates and fears of a global economic slowdown. The MSCI ACWI Small-Cap Index is trading near a 20-year low on a relative basis versus large caps. Now, as the Federal Reserve (Fed) appears to be pivoting to a more dovish stance, potentially leading to an easing of financial conditions, the outlook for small cap stocks is brightening.

The path for small cap companies, or those with a market value of US$6 billion or less, to obtain financing should be easier. And the initial public offering (IPO) pipeline, which had shrivelled to a trickle, should start to flow again, providing a fresh set of opportunities.

That said, a supportive macro-economic backdrop is only part of the overall story for small-cap stocks. These companies often need a structural growth runway to thrive. And many of the opportunities can be quite idiosyncratic or specific to each company.

Relative valuations for small caps are near 20-year lows

MSCI ACWI Small Cap Index P/E (NTM) relative to MSCI ACWI Large Cap Index

As at 31 December 2023. P/E = price-to-earnings. NTM = next twelve months. P/E = price-to-earnings. NTM = next twelve months. The Y-axis represents the ratio between the P/E of MSCI ACWI Small Cap Index and the P/E of the MSCI ACWI Large Cap Index. Sources: Capital Group, FactSet, MSCI

Small-cap stocks also tend to be associated with the US, the largest category in this asset class. But we are finding an increasing number of opportunities around the world, in markets that one might not typically think of as havens for smaller innovative growth companies, such as Japan, the Nordic countries of Sweden and Norway, southern European countries such as Greece, and prominent Asian markets, notably India.

And despite lagging large caps in recent years, smaller companies have been an important source of return in global equity markets. They have outpaced their larger brethren close to 70% of the time in rolling three-year periods since 2000. In this article, we highlight areas of opportunity that we find illustrate the multi-faceted and dynamic nature of the global small-cap space.