NEW YORK, (June 20, 2024) – Small Cap Value stocks have dramatically underperformed the S&P over the last 5 years with the S&P up 95% and small-cap value stocks up only 50%. This underperformance has resulted in a large valuation gap with small cap value stocks trading at only 16.2x Forward EPS estimates and 11.1x 2025 vs. the S&P at 22.7x and 19.8x. This valuation gap exists even though small cap value stocks have almost double the growth rate of the S&P 500. In addition, the average dividend yield of the small cap value index is 3.6% vs. the S&P 500 at 1.4%.
We believe that small cap value stocks are an attractive asset class that should be represented in diversified portfolios. The small cap value sector increases portfolio diversification as it is less correlated with the broad market with a 1.1x correlation to the S&P vs. large cap sector funds such as the Dow or Nasdaq with 0.94x at 1.15x correlation. In addition, small cap stocks generally have superior growth prospects as they are in the earlier stages of the business life cycle. Also, smaller companies are often attractive acquisition targets for medium to large cap companies. Finally, small caps have less analyst coverage, providing an advantage for active management.
Small cap companies are perceived to be more interest rate sensitive than large cap defensive companies as they generally have higher debt levels and rarely have net cash positions as some large cap technology companies do. Over the last two years small caps have underperformed larger cap companies as interest rates rose substantially driven higher by restrictive monetary policy. Year to date small cap stocks have underperformed the S&P by 13.4%. Small cap value stocks have, however, outperformed large cap companies over the last 20 years, indicating that small caps are an attractive asset class for long-term investors.
We are forecasting that 2024 will be the Year of Global Rate Cuts. The BOC and ECB rate cuts starts the global wave of rate cuts and will put pressure on other central banks as currency moves reduce the growth of countries slow to cut. We believe that international central banks are likely to lead the Fed in rate cuts as overseas economies are far weaker than the US. We forecast that the declining rates and the increase in global liquidity combined with the AI Boom will drive the S&P to $5,750.
We believe that small cap value stocks are a timely investment as the Russell 2000 Index (small cap index) has underperformed the S&P 500 Index through 2024. We believe small cap stock may perform well because (1) interest rates are declining, (2) of the fundamental attractiveness of the sector, and (3) of their current valuation discount with less correlated returns.