If small-company stocks make up a small part of your portfolio, you’re not alone. The consistent outperformance of larger companies over the past few years has left many investors under-allocated to littler ones, argues one investment manager. He believes now is the time for small companies to shine.
Daniel Skubiz, senior portfolio manager at Ziegler Capital Management (ZCM), says that in the past, what he calls “extreme” periods of lopsided outperformance by large-cap stocks have provided attractive opportunities to find better returns in small-caps.
The best example of such an extreme is the bursting of the dot-com bubble in 2000, Skubiz says. Investors had been plowing money into growth plays with new-technology themes.
“We don’t think a bubble exists in large-cap technology stocks today,” he says, but after the 2000 tech wreck, “small caps went on a long run at outperformance that didn’t end until 2014.”
Right now, small-cap stocks—those with a market capitalization of less than US$2 billion, approximately—are trading with valuations roughly in line with their 10-year average multiples and at a deep discount relative to large-cap stocks, Skubiz says. For instance, the price-to-earnings ratio of the
iShares Russell 2000 ETF
(ticker: IWM) on a 12-month forward-looking basis is 22.01 versus the 10-year average of 19.5, according to Skubiz.
Small caps derive roughly 75% of their revenue from the U.S., compared to about 60% for large caps, he says. That’s an important consideration given the massive government investment in infrastructure now.
Smaller U.S.-based companies also offer a nice geopolitical hedge as the war in Ukraine drags on and conflict in the Middle East and elsewhere flares up. What’s more, they are relatively insulated from currency swings, which could negatively impact the foreign operations of larger companies as the U.S. dollar continues to strengthen.
Those fundamentals characterize small-cap stocks. Yet many high-net-worth individuals and wealth managers have spent the past several years seeking those same traits by investing in private companies through private-equity and venture capital funds. That’s a mistake, Skubiz says.
“There’s more money chasing fewer opportunities,” he says. “You’re getting a riskier environment for private equity because there aren’t as many high-quality opportunities. At the same time, valuations of private companies aren’t marked-to-market, as public companies are, so they’re worth what someone says they’re worth. Another risk to investing in private markets is the inability to get out of a position quickly—most funds require investors to lock up their capital for five years or more.
ZCM’s small-cap strategies, which are made for separately managed accounts, focus on quality within the small-cap universe. The Chicago-based firm’s MVP Small Cap Core Strategy has 80 stocks, a more diversified portfolio than could be created by picking a handful of stocks or investing in private equity, Skubiz says. The strategy’s emphasis on industrial stocks and de-emphasis on financials and biotech, has allowed it to outperform its benchmark, the Russell 2000 index, for the past three years. In 2023, the strategy returned 17.6% versus 16.9% for the Russell 2000.
Skubiz cautions against reading anything into what small caps are likely to return or how volatile they are likely to be based on the index, which, as he puts it, “is full of non-earners.” The benchmark index rallied 14% in the fourth quarter as investors bet that a lower interest-rate environment would give a boost to those less-productive companies.
In any case, “this is a much better environment for active managers going forward,” he says “Higher quality is going to rule the day, especially as corporate cash flows recover.”
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