Conditions look good for this forgotten asset class

After an extended period of underperformance compared to large-cap stocks, small caps are beginning to see favourable valuations, says Francis Gannon, co-chief investment officer and managing director at Royce Investment Partners.

On the Soundbites podcast this week, Gannon said small caps are working their way out of a years-long earning recession, benefiting from reshoring and re-industrialization trends in the United States, as well as the business efficiencies and earnings potential brought by AI.

“You’d have to go back 20, 25 years to see the same relative-type valuation opportunity that we’re seeing today,” he said. “We think you will actually see some significant growth in the small-cap space over the next, really, two years.”

Gannon said that despite appearances, the benefits of AI are not restricted to the mega-cap growth companies.

“Small-cap companies will benefit from the efficiencies of AI, and then, they are also part of the AI machine, if you will.”

One example is Oklahoma-based AAON, Inc., which manufactures heating, ventilation and air conditioning equipment for commercial and industrial indoor environments.

“It is involved in cooling a lot of the rooms where the chip stacks are, from an AI perspective,” he said. “And the growth there is exponential.”

Another “tailwind story” for small-cap stocks, he said, is that they’re under-owned. The percentage of small-cap stocks in the Russell 3000 index stands at 4.4%.

“That is one of the lowest numbers we’ve seen … going back to the late 1970s,” he said. “That number usually is closer to 8%, just to show you how much small caps are out of favour right now. As people think about diversifying away from that concentration in the large-cap space, I think small caps are a wonderful alternative asset class for them to be looking at.”

As for headwinds, Gannon said interest rates remain a concern for many investors.

“We know that 40% of the Russell 2000’s debt is variable rate, and so anything around interest rates could really affect those lower-quality businesses,” he said.

With over 44% of the Russell 2000 comprised of non-earning companies, portfolios that include small-cap stocks beg for hands-on active management.

“You want them to be able to find these durable businesses that aren’t relying on the bond market or banks to grow their business,” he said. “They’re actually generating free cash flow, investing that free cash flow, they have earnings, they can grow their business in a lot of different ways.”

Gannon said small caps have been in a corrective phase so far this year, down 27.5% in April from their most recent high in November last year.

“A lot of the uncertainty and fear in the market was really priced into the small- and micro-cap market relatively quickly in the month of April,” he said.

And while there has been some recovery in recent weeks, they’re still down over 15% from November. But this is not overly worrisome for an equity class that routinely sees intra-year corrections in the double-digit range, but still manages to grow over time.

“We’ve done a lot of different studies that look at this,” he said. “The average intra-year decline for the Russell 2000 going back to 2000 is actually about 20% and the average calendar return is 9.2% over the same time period.”

Last year, for example, the Russell 2000 faced a mid-year decline of 10% but finished up 11.5%.

“So intra-year declines are common, but this volatility is creating an opportunity for long-term investors,” he said.

“I genuinely believe small caps are a forgotten asset class in a world where everybody is looking for alternatives. Small caps are a wonderful public way to invest in today’s market,” he said.

“Here you have an asset class that we know has a valuation advantage over large [caps]. We know they’re under-owned at the moment. And so any diversification away from the large-cap space and broadening of the overall market will really benefit small caps and in a way we haven’t seen in a long period of time.”

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This article is part of the Soundbites program, sponsored by Canada Life. The article was written without sponsor input.