Partner Insight: The Outlook for US Smaller Companies Looks Increasingly Compelling

Now is not the time to wait on the sidelines

clock • 4 min read
Partner Insight: The Outlook for US Smaller Companies Looks Increasingly Compelling

Key points

  • While the US equity market has become increasingly concentrated at the top end over the past decade, smaller‑company valuations are at their most compelling levels in decades.
  • History shows that as high concentration in the S&P 500 Index begins to unwind, a new cycle of small‑cap outperformance usually begins
  • Shifting trends in the US economy are particularly supportive of smaller companies, providing a potential catalyst for higher earnings growth..

Watchful confidence continues to characterize the US equity market as the economy, consumer confidence, and corporate profits all show surprising resilience. One source of worry, however, is the high level of concentration at the top end of the equity market, as investors continue to pile into a handful of richly valued mega‑cap companies. In stark contrast, we believe company valuations at the smaller end of the scale are at their most compelling levels in decades. This is creating opportunities to add exposure to high‑quality, growth‑oriented businesses with the potential to compound returns over time. Now is not the time to wait on the sidelines.

Beware of Large‑Cap Concentration Risk

A great deal of ink has been dedicated to explaining how, for more than a decade, the performance of the US equity market has been dominated by a small group of mega‑cap, growth‑oriented companies. This trend has seen the US equity market become highly concentrated at the top end, with valuations of a small group of large companies increasingly hard to justify. Importantly, history tells us that as high concentration in the S&P 500 Index begins to unwind, a new cycle of small‑cap outperformance usually begins. As money is reallocated out of highly concentrated, potentially overvalued names, it must find somewhere to go, and this has tended to be the more attractively valued stocks further down the capitalization scale.

What's more, it shouldn't take a huge amount of capital flowing into the small‑cap domain to move the dial significantly. As of June 30, 2023, the five largest stocks alone in the S&P 500 Index had a market capitalization of 3.3x that of the entire smaller‑companies Russell 2000 Index. So every incremental dollar reallocated into the small‑cap sector is a tailwind to relative performance. If even a fraction of the value of the five largest US stocks made its way into smaller companies, the overall impact could be substantial.

The Small‑Cap Valuation Story Looks Attractive

US smaller‑company stocks have historically traded at a premium to large‑caps, a direct reflection of their higher relative risk/return profile. In recent years, however, this valuation trend has reversed; not only are small‑cap stocks trading at a discount to their larger counterparts, the discount has reached historically wide levels, effectively detaching from its long‑term "normal" range. Over the past 50 years, there have been only two occasions when small‑cap stocks have traded at similarly wide relative discounts—during the 1999-2000 dot‑com boom and bust and in the 1973 oil crisis.

On an absolute valuation basis, smaller companies are also trading below long‑term average levels. This partly reflects the more difficult near‑term environment, with smaller companies generally more sensitive to the ups and downs of the US economy. However, current valuation levels also appear to suggest expectations of a potentially protracted US economic recession. This seems an overly bearish outcome, in our view, and one that, at this stage, appears unlikely based on the mosaic of information available.

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This post was funded by T. Rowe Price

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Key points

  • While the US equity market has become increasingly concentrated at the top end over the past decade, smaller‑company valuations are at their most compelling levels in decades.
  • History shows that as high concentration in the S&P 500 Index begins to unwind, a new cycle of small‑cap outperformance usually begins
  • Shifting trends in the US economy are particularly supportive of smaller companies, providing a potential catalyst for higher earnings growth..

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