All-weather opportunities: four current tailwinds for U.S. small-cap stocks

This year began on a positive note for U.S. equity investors, with stocks across the market capitalization spectrum rebounding from 2022’s declines. However, that promising start to 2023 was disrupted in early March, when the rising-rate vulnerabilities of a select group of U.S. banks fueled a liquidity crisis and deposit outflows, leading to fairly sudden collapses for three small to midsize institutions. While the banking system has since stabilized, the failures and a tightening in credit conditions had a disproportionately negative impact on small-cap stocks broadly, which lagged large caps as the stocks of many smaller banks struggled to restore investor confidence. As of September 1, small caps continued to trail their larger peers on a year-to-date basis, as measured by the performance of a small-cap benchmark, the Russell 2000 Index (Russell 2000), relative to large-cap indexes.¹

The recent silver lining for small-cap investors: relative to large caps, broader representation across sectors

While the banking system’s instability was a key driver of small caps' lagging early 2023 results, an unrelated factor further widened the disparity, while also illustrating what we consider to be a relative strength for small caps and the breadth of current opportunities that they offer. Much of the year-to-date performance shortfall for small caps can be attributed to the unusually strong early 2023 gains of a handful of large- and mega-cap technology stocks.²

Lifted by optimism over the profit potential from accelerating adoption of artificial intelligence, these stocks lifted the otherwise mostly flat results of broad large-cap benchmarks such as the Russell 1000 Index (Russell 1000) and the S&P 500 Index (S&P 500). As of May 24—when the trend reached a peak—the 7.9% year-to-date total return of the S&P 500 would have been slightly negative if not for the positive contributions of just 8 stocks in the 500-stock index.² Collectively, those 8 tech names had contributed nearly 98% of the market’s year-to-date return as of May 24. The top-heavy, tech-reliant nature of large-cap results is further illustrated by the fact that the information technology sector accounted for nearly 65% of the S&P 500’s total return through the first six months of 2023, with consumer discretionary generating another 20% and communication services a further 18%.³

While the large-cap market’s year-to-date performance gains broadened across a wider range of sectors in July and early August, small caps’ overall gains continued to be spread more evenly across a variety of stocks and sectors. Through June, healthcare was the Russell 2000’s top year-to-date contributor, accounting for 36% of the index’s year-to-date total return.⁴ Information technology—the sector that contributed almost two-thirds of the S&P 500’s return—accounted for just 19% of the small-cap return.⁴

Those discrepancies help explain why small caps currently have broader representation across sectors than large caps—a gap that’s widened in recent years given the growing representation of tech-oriented companies. The Russell 2000 has larger weightings than the large-cap Russell 1000 in sectors such as industrials, which made up 18.0% of the small-cap benchmark as of July 31, 2023, as well as healthcare (15.7%) and financials (15.1%).⁵ However, the Russell 2000 has a more modest 12.6% weighting in technology relative to that sector’s 30.9% weighting in the Russell 1000.  

Source: FTSE Russell, as of 7/31/23. The Russell 2000 Index tracks the performance of 2,000 publicly traded small-cap companies in the United States. The Russell 1000 Index tracks the performance of 1,000 publicly traded large-cap companies in the United States. It is not possible to invest directly in an index. 

The relatively balanced sector representation across small caps is an important long-term attribute for the asset class from the perspective of building a portfolio that’s broadly diversified across sectors as well as the market capitalization spectrum. Furthermore, from a short-term performance perspective, we’ve identified four tailwinds for small caps as we pursue opportunities at the individual security level across the asset class:

1 )      Historically attractive valuations for small-cap stocks—Small caps’ recent underperformance relative to large caps has left the Russell 2000 at its most inexpensive level relative to large caps in more than two decades, dating to the period when the technology stock bubble burst in 2000, according to FactSet. As of June 30, the index’s relative price-to-earnings ratio based on the past 12 months of earnings was 0.51 as measured against the S&P 500. That relative valuation difference made small caps far less expensive than their long-term average of 0.93 dating to June 1, 1998.

Source: FactSet, July 2023. The Russell 2000 Index tracks the performance of 2,000 publicly traded small-cap companies in the United States. The S&P 500 Index tracks the performance of 500 of the largest publicly traded companies in the United States. It is not possible to invest directly in an index. Trailing price to earnings (P/E) is a valuation measure comparing the ratio of a stock’s price with its earnings per share over the past 12 months. Past performance does not guarantee future results.

2 )      The impact on small-cap stocks if there’s a recession—Although many recent U.S. economic data points have come in stronger than expected, a recession remains a near-term possibility, given the extended economic impact of the U.S. Federal Reserve’s (Fed’s) recent interest-rate increases, the prospects of still more hikes to come, and the headwinds that higher borrowing costs create for the broader economy. However, we believe that any such recession is likely to be a relatively mild and short-lived downturn relative to historical averages, and small caps could be well positioned to outperform exiting such a recession. While large caps have historically tended to outperform small caps during recessions—that is, by declining to a lesser degree—the performance edge has often flipped in the postrecession recoveries that followed. In fact, small caps have outperformed large caps in each of the 12-month periods that followed the past six U.S. recessions declared by the National Bureau of Economic Research.⁶ The margins for small caps have been big, with an average 28.4% return for the Russell 2000 Index during those periods versus 15.6% for the S&P 500 Index. 

Source: eVestment Alliance, August 2023. Recession periods are as defined by the National Bureau of Economic Research.  The Russell 2000 Index tracks the performance of 2,000 publicly traded small-cap companies in the United States. The S&P 500 Index tracks the performance of 500 of the largest publicly traded companies in the United States. It is not possible to invest directly in an index. Past performance does not guarantee future results.

3)       Forgotten asset class—We consider small caps to be an underowned asset class, given the fact that small-cap mutual fund flows have not only lagged other major fund categories, but have actually been negative overall dating to the latter stages of the global financial crisis in July 2009, according to Morningstar data. We view small caps as an asset class with an abundance of bottom-up, active fundamental investing opportunities, and we believe that greater recognition of these opportunities will eventually usher in an era of positive flows, which would provide support of asset prices across small caps broadly.

Source: Morningstar Direct, Manulife Investment Management, July 2023.  

4)        Sector outlook—Our team currently sees an abundance of bottom-up stock opportunities within sectors where we currently have favorable views, such as technology, industrials, and healthcare. Within tech, we remain persistently bullish on the security software industry, where we expect sustained revenue growth with strong margins. In addition, we could consider semiconductors to be a stock pickers’ market, particularly in semiconductor applications in the automotive industry and in defense communications.

Regarding industrials, we currently see the most favorable investment environment since the 2000s, driven by capital spending on infrastructure and domestic manufacturing made possible in part by recent U.S. government stimulus spending including the $1 trillion Infrastructure Investment and Jobs Act, the nearly $400 billion in clean energy spending in the Inflation Reduction Act,  and the $280 billion CHIPS and Science Act to boost the domestic chip-making industry and scientific research. Among the potential beneficiaries of this spending are engineering and construction companies, materials providers, and manufacturers of highly engineered industrial products.

In healthcare, demographic trends stemming from America’s aging population remain a long-term tailwind. In the short term, healthcare services utilization rates, hospital staffing, and supply chains have all recently been improving, and we believe these trends are likely to drive higher industry volumes and profit margins. In addition, we see valuation dislocations across many healthcare companies and industries that historically have traded at premiums to the overall market.

Risks to small-cap outperformance potential

While we maintain a positive long-term outlook for small caps, several near-term headwinds pose risks that complicate the outlook through the rest of this year and perhaps beyond. Chief among them is the path that inflation takes through the end of this year and the pace of any additional rate increases that the Fed may approve, as any further escalation in borrowing costs could disproportionately weigh on those smaller companies that are dependent on credit to grow. Further complications for smaller companies could arise if we see any recurrence of the liquidity problems that many banks experienced earlier this year.   

Small caps for the long run

Despite these current risks, we see an abundance of many high-quality smaller companies with strong fundamentals and resilient balance sheets to help navigate an environment in which credit has recently become more expensive. Given these bottom-up opportunities and the historically low valuations across small caps broadly, we see a fertile current environment for active fundamental investing emphasizing a core small-cap approach, with blended exposure across the growth and value equity style spectrum.      

1 FactSet, as of 9/1/23. 2 S&P Dow Jones Indices, May 2023. 3 S&P Dow Jones Indices, July 2023. 4 "Russell 2000 Index quarterly chartbook, July 2023, Covering Q2 index performance,"  FTSE Russell, July 2023. 5 FTSE Russell 2000 Index and Russell 1000 Index factsheets, July 2023. 6 eVestment Alliance, July 2023.