Though by no means foolproof, troughs in the Conference Board’s Leading Economic Index (LEI) — a composite index of economic and market variables that in aggregate purports to anticipate potential turning points in the business cycle — historically have augured well for the performance of small-cap stocks relative to large caps. Recent LEI data suggest the metric may be bottoming out after a long period of decline, at least partly due to some inflation-friendly data.
At 2.6% and 2.9%, respectively, y-o-y increases in the headline and core personal consumption expenditures price indexes eased in December to early-2021 levels. Mixed employment data, however, has clouded the forecast. This disparate data has kept “higher for longer” rates firmly in play and serve as a good reminder of why we focus on the factors we can control rather than trying to make timing calls.
Identify good businesses at attractive valuations
In the final analysis, investors can control only which stocks they buy and how much they pay for them. We believe those who devote their efforts to identifying and investing in good businesses at attractive valuations may see the most success over the long run, and current small-cap valuations continue to suggest an environment ripe for finding such companies despite strong gains in 2023.
The Russell 2000 appears very cheap on a trailing P/E basis, which is at a 19% discount from the historical average and a 41% discount from the S&P 500. Notably, the last time small-cap valuations hit similar lows was in March 2009 amid the global financial crisis; the Russell 2000 nearly doubled in the 12 months that followed.
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Further, it is worth remembering that a discount for small-cap stocks is a relatively recent phenomenon. For most of the period between 2003 and 2017, small caps traded at a premium to large caps, and smallcap stocks — small-cap value stocks, in particular — have outperformed their large-cap value and growth counterparts over full investment cycles. Mean reversion historically has had a powerful influence over financial markets and may serve as an additional tailwind for small stocks.
As compelling as small-cap valuations may be at the index level, buying the index is not likely a path to optimal returns, in our view. As Warren Buffett, quoting Benjamin Graham, observed, a “wildly fluctuating market means that irrationally low prices will periodically be attached to solid businesses”.
Small caps represent one such wildly fluctuating market, and its pronounced volatility and inefficiency historically have created opportunities for skilled active managers to generate alpha or excess return relative to a benchmark index — more so than any other equity asset class.
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Given that 42% of the companies in the Russell 2000 were unprofitable as of Dec 31, 2023, versus only 6% of the S&P 500 — we think sorting the wheat from the chaff is a worthwhile endeavour in the broad and diverse small-cap universe.
Regardless of the Fed’s actions in 2024, it seems likely companies that are cheap for a reason will continue to face a challenging operating environment, while many of those with solid businesses and catalysts for improvement may progress towards valuations more consistent with historical levels.
Bill Hench is portfolio manager and head of the small cap team at First Eagle Investments
