Legendary musician Prince admonished us to “party like it’s 1999,” but today, as a small-cap stock investor, I might turn the calendar forward one 12 months to 2000.
That’s since the NASDAQ peaked at 5048 in March 2000 and fell almost 35% in April. The following 18 months weren’t a celebration either. Many formerly successful technology stocks, including Pets.com and Priceline, lost all or nearly all of their value. Even established firms like Intel, Cisco and Oracle saw big declines. In fact, trillions of dollars evaporated during this infamous period that became often called the dot-com bubble.
But for some investors, the aftermath of the dot-com bubble was top-of-the-line times ever to deploy capital. It was an all-too-rare opportunity to accumulate significant positions in quality firms that the market simply didn’t want.
I imagine quality small caps are in the same position today.
Today, small caps are unloved, unwanted and uninvited to the party. And there was a celebration — an enormous one, thrown by a handful of mega-cap tech stocks, particularly those considered pioneers in artificial intelligence (AI).
The parallels between AI mania and the dot-com era are hard to miss. In 1999, any company that described its Internet as reputable was a darling of the market. Spoiler alert: it didn’t end well. Still, it was a superb time for selective stock picking, and there are familiar echoes of today’s Canadian small-cap tech stocks.
What happens now – Why the massive discount?
In life, as in investing, every part happens for a number of reasons. And this also applies to absolutely the and comparatively low valuations of small-cap stocks.
1. Large pools of capital are increasingly privatized.
Pension funds and other large institutional investors wish to generate alpha. To achieve this, they’ve historically invested a portion of their investments in publicly traded firms with small market capitalizations. Today, these investors are shifting their portfolios away from public markets and toward private markets. When only a handful of stocks generate a lot of the profits, asset managers find it difficult to outperform. Therefore, private equity’s diversification advantages and alpha potential appear attractive. For example, Yale University’s endowment fund now has nearly 40% in private equity and enterprise capital funds, in comparison with just 5% in 1990. As demand for small-cap stocks declines, so do their valuations.
2. Investors are in search of performance.
We’ve all heard of the Magnificent Seven, the mega-cap tech stocks which were driving stock returns recently: Nvidia, Microsoft, Amazon, Apple, Alphabet, Tesla and Meta. To put things in perspective, Apple is price greater than the entire smaller U.S. firms included in the whole Russell 2000. Investors are in search of returns from large-cap firms, and the NASDAQ’s five-year track record is superb. This was also true in January 2000.
3. There is the macro and the micro.
On a macroeconomic level, the small-cap market has turned a corner in 2021 and has been facing headwinds for nearly 2.5 years now. Rising rates of interest have been priced into the valuations of small-cap firms, and since debt dynamics differ from their larger peers, smaller firms are inclined to be sold first, ahead of a possible recession. Smaller firms, particularly those in earlier stages of growth, are inclined to carry more debt, and that debt tends to have a shorter average maturity – 5.7 years versus 8.2 years – putting them at greater risk in a tighter monetary environment. Smaller firms even have fewer sources of financing to depend on.
What are the expansion catalysts?
Given this, what are the opportunities in small-cap stocks? Smaller firms are inclined to be on the forefront of a recovery. If monetary policy becomes more expansionary, perhaps as early as the primary quarter of 2024, small-cap stocks are more likely to react strongly. As performance leadership continues to say no, institutional funds, amongst other investors, will look elsewhere, and high-quality small caps are one place where they’re more likely to deploy capital.
Because small caps are inclined to be less liquid, a rise in demand could potentially result in significant increases in stock prices and revaluation. Mean regression suggests that small-cap company valuations will eventually return to their long-term average.
The M&A market is one other source of potential upside for small caps. Willing sellers are hard to seek out today. Many quality firms entered the market with high valuations, and management teams have develop into psychologically accustomed to those higher valuation metrics. But over time, its shareholders and board members will accept the brand new reality and realize that an acquisition would be the best path to further growth.
The small-cap premium historically implies that small-cap stocks outperform their large-cap counterparts over the long run. For example, from 2000 to 2005, after the telecommunications boom and bust, the S&P 600 outperformed the S&P 500 by a median of 12% per 12 months. We are in a time where small caps have a bearish ratio in comparison with large caps.
As of September 2023, the forward P/E ratio is The S&P 600 is at 13.8. The last two times the S&P 600 had a forward P/E ratio on this range were throughout the global financial crisis (GFC) and initially of the worldwide pandemic. In each cases, those investors who put their capital into small caps were well rewarded. There may very well be the same opportunity today.
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Photo credit: ©Getty Images / jjwithers
