Institutional investors who want to unlock the opportunities in U.S. small-cap equities need to understand the complex economic and fundamental dynamics driving this subsector. It holds appeal now following the recent market pullback that is due, in large part, to the slowdown in the economic reopening tied to the Delta variant spread, said Ralph Bassett, CFA, head of U.S. equities for abrdn.
“Until several months ago, small caps were tracking in-line with our expectations. They were delivering very good stock-level performance driven by an improved corporate earnings outlook and supported by a broad reacceleration in the economy” as it opened up following the decline in the COVID-19 pandemic, Bassett said. But while the subsequent spread of the Delta variant has impacted some small-cap companies, specific sectors are thriving. “The more profitable companies with more stable growth are leading the way.”
Active stock selection is key to a nimble and informed approach on U.S. small caps, one that can respond to the complex dynamics within this asset class, Bassett said. “It’s a lot easier in small caps to beat the benchmark by being active.” Abrdn also takes a long-term perspective on the sector: “We’re consistently looking out three-plus years at companies that can deliver growth, and growth that isn’t predicated on any one prevailing economic environment,” he said.
Unearth high quality
U.S. small-cap companies continue to be a compelling story. They tend to be the companies driving innovation and growth from the ground up and that have historically outperformed large-cap companies over the long term, Bassett said. Since the turn of the century, U.S. small caps have generated a cumulative total return of 500%, materially higher than the 367% return for large caps.
Investors who have been wary of small caps have had cause for concern since the pandemic, given their high correlation with U.S. economic growth, Bassett said. Even prior to the spread of the Delta variant, smaller companies have faced numerous headwinds, from ongoing supply-chain bottlenecks to labor market disruptions to continued uncertainty, he explained. These factors have led to subdued performance for many small caps, specifically those with a value tilt.
Related to the most recent market selloff, Bassett said that he and his team believe expectations for cyclical companies got ahead of themselves. “As we’ve come through July and August, there’s been a reset in terms of people questioning not only the earnings expectations for many of these companies next year, but [also], importantly, the multiple that investors are willing to put on that.”
Regardless of the broader market environment, an active, selective approach in small caps can uncover opportunities. “There’s been a huge migration in the last few months toward what we would call higher-quality companies, those with very sustainable growth and, importantly, those with strong profitability,” Bassett said.