Celebrating 25 Years of Small Caps
The Jennison Small Cap Core Strategy 25th Anniversary page highlights this milestone with exclusive content that looks back on the team’s long tenure.
The current large-cap outperformance cycle is in its 12th year and we believe it is nearing an end. As a consequence, small-cap companies currently account for 4.0% of the overall U.S. equity market, when historically they have averaged 7.5%.1 The last time small-cap stocks reached this low market capitalization level was in March 2020 with the only other observation occurring in the 1930s.1 With room for the asset class to advance toward its historical average, this dynamic could be creating an attractive entry point for long-term investors as they revisit the role of small caps in diversified plans.
In addition, after a significant decline during the COVID-19 pandemic, merger and acquisition activity (M&A) has recently improved. While the total dollar value of deals is still down, overall transactions are approaching pre-pandemic levels.2 Mergers and acquisitions in the broader economy often support small-cap stocks. When large companies acquire small caps at a premium to current value, it can often lead to a bump in the stock prices of the acquisition targets and elevate the valuation of similar businesses in the same industry. Going forward, we anticipate the cadence of transactions to improve as the stock market and overall valuations adjust to a higher interest-rate regime. In that environment, well-capitalized companies should continue to create value through strategic M&A, which has historically supported small-cap valuations.
We believe market conditions that favored these extreme outcomes have shifted and are showing signs of reversing, which can be observed in the recent relative performance of small-cap versus large-cap stocks (Exhibit 1).
The relative price to earnings multiple of the Russell 2000 Index versus the S&P 500 Index was last observed at current levels during the dot-com bubble in the early 2000s (Exhibit 2). Following this period of depressed relative valuations, the Russell 2000 Index outperformed the S&P 500 Index by more than 50 percentage points on a cumulative basis (from 10/9/2002–10/9/2007).3
There is one common denominator across these valuation and structural market trends: significant concentration among market leaders. As of October 2022, the five largest U.S. stocks by market capitalization represent 20% of the S&P 500 Index.4 For perspective, these five mega-cap stocks are three times the size of the entire Russell 2000 Index. In addition, they trade at seven times sales, while the Russell 2000 Index trades at two times sales.5
The past decade provided a backdrop for a select few company valuations to soar past the trillion dollar threshold. This also resulted in outsized market weightings for these companies in the S&P 500 Index, which peaked in the fourth quarter of 2021 and have been declining ever since.
The current trend could have implications for the potential trajectory of small caps. As Exhibit 3 shows, historically, when mega-cap stocks started to lose market cap, small-cap stocks tended to outperform. For example, the weight of the top five S&P 500 constituents peaked at 24% in 1973, namely when AT&T, Eastman Kodak, Exxon Mobil, General Motors, and IBM dominated the index. When these mega-cap names started to lose market capitalization, it coincided with the beginning of a prolonged period of small-cap outperformance. In March 2000, there was a similar breakdown of the largest stocks. This was followed by a small-cap cycle of outperformance that lasted a decade.
We believe the current global market backdrop is an opportunity for investors to assess and adjust strategic asset allocations.
First, small-cap stocks represent a compelling way to diversify investments from heavily concentrated large-cap indices as narrow market leadership evolves and becomes more broad. Over time, markets often revert to the mean. With small-cap valuations significantly below large-cap stocks', and their overall representation in the broader stock market near all-time lows, small caps seem well positioned for the long term.
Second, we believe the optimal way to allocate to small-cap companies is from a prudently diversified portfolio relative to either the Russell 2000 or Russell 2500 Index. Navigating many uncertain economic backdrops over our 20+ year history has solidified our view that focusing on what we identify as quality business models led by capable management teams is the best approach. In the current environment, we are cautious of highly levered companies, or those raising new debt. Access to capital has become challenging and a larger percentage of earnings for many companies will go to service debt. That said, those companies with leading positions in attractive industries with dependable cash flows and the ability to fund their own growth should be able to gain market share and will remain attractive in a high-inflation, higher-cost-of-capital world. We are also focused on businesses that can maintain pricing power by passing through higher costs to their customer base, which should lead to margin improvements when inflation and supply chain pressures decline.
We believe we are approaching an exciting period to be exposed to small-cap companies and are confident our disciplined process makes our portfolios well positioned to capitalize on this potential opportunity.
1 As of April 22, 2022. Source: Jefferies Equity Research SMID-Cap Themes—Focusing on the balance sheet; 20 GARP names to chew on
2 November 2022. Source: McKinsey & Company: Strategic M&A in US banking: Creating value in uncertain times
3 Source: Russell, Standard & Poor’s
4 Source: Standard & Poor’s. As of October 31, 2022.
5 Source: Russell Investments. As of October 31, 2022.
The views expressed herein are those of Jennison investment professionals at the time the comments were made and may not be reflective of their current opinions and are subject to change without notice and should not be considered investment advice.
Certain third party information in this document has been obtained from sources that Jennison believes to be reliable as of the date presented; however, Jennison cannot guarantee the accuracy of such information, assure its completeness, or warrant such information will not be changed. Jennison has no obligation to update any or all such third party information. There is no assurance that any forecasts, targets, or estimates will be attained.