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Why A Long-Term Allocation to Smaller Companies Makes Sense

Executive Summary

  • U.S. smaller companies have lagged their larger counterparts over the past year. However, the fundamental picture remains supportive, in our view.
  • Moreover, there are compelling reasons for maintaining a long‑term, strategic allocation to the smaller-company sector.   
  • The U.S. offers a particularly supportive, pro‑business environment where entrepreneurship is esteemed and small business success stories are championed.

With the S&P 500 Index recently scaling new, all‑time highs, U.S. smaller companies, in comparison, have lagged their larger counterparts over the past year. This has prompted some investors to question the outlook for smaller companies, as well as their continuing exposure to the asset class. However, not only does the near‑term fundamental environment remain supportive, in our view, but there are also compelling reasons for maintaining a strategic, long‑term allocation to smaller companies.

Understanding Smaller Company Characteristics

So, what is it that is currently weighing on the small‑cap market? Some have suggested that the combination of slowing global economic trends and the U.S.‑China trade war represent a particularly risky landscape for U.S. smaller companies. Indeed, smaller companies tend to hold higher levels of debt relative to cash and revenues, so they are generally more sensitive to the health of the broader economy.

However, while there is inevitably some flow through from a weaker global economy, the U.S. economy continues to expand at a healthy rate. Small‑cap companies tend to be more domestically focused, with a relatively low international exposure, so they are generally more insulated from global economic trends than larger‑company counterparts. Meanwhile, it is true that smaller companies are not immune from the impact of the China trade war. Given that these businesses import and export both materials and components, any disruption here is likely to result in volatility. However, it is arguable that the trade war could also potentially provide opportunities for certain smaller U.S. companies as new domestic suppliers are sought to fill some of the gaps previously met by Chinese companies.  

Late‑Cycle Concerns Have Prompted Some Rotation

Concerns about the late stage of the economic cycle have led some investors to reduce their smaller‑company exposure. Already more than 10 years into the current expansionary phase, we are likely getting closer to the end of the economic cycle. While the appeal of smaller companies is that their size makes them more responsive to changes and opportunities, it also means that they tend to be more vulnerable during periods of slowdown. Accordingly, as we move deeper into the current cycle, some investors have started to pivot out of smaller companies in favor of larger, more established companies offering stable earnings, lower debt, and more substantial cash buffers.

Why the Fundamental Environment Remains Encouraging

Despite the late stage of the economic cycle, we believe a number of factors remain supportive of the asset class. First, consensus expectations for the next six to 12 months are for U.S. smaller companies to deliver superior growth to their larger counterparts, while valuations also appear more reasonable. While we do not know if this growth will be achieved, the upbeat consensus view signals a generally supportive landscape. Meanwhile, mergers and acquisitions (M&A) activity also continues to underpin small‑cap performance. A combination of tax reform, reduced regulation, and, importantly, larger companies’ ongoing searches to “buy in” small‑cap innovation should continue to stimulate further M&A activity. Finally, the U.S. government and central bank have made clear commitments to do whatever is necessary to arrest any material slowdown in the economy.

(Fig. 1) Comparing Long‑Term Performance
Smaller companies have generated superior long‑term returns versus larger counterparts
 

Past performance is not a reliable indicator of future performance.
Sources: FTSE Russell (see Additional Disclosures), and S&P (see Additional Disclosures). Data analysis by T. Rowe Price.
 

Revisiting the Rationale for a Long‑Term, Strategic Allocation to Smaller Companies

Moreover, there are compelling reasons for maintaining a long‑term, strategic allocation to the smaller‑company sector. Principally, these include the potential to exceed large‑cap performance over the long term, portfolio diversification, and the opportunities afforded through well‑researched stock selection by the greater dispersion of returns on offer.

Historically Superior Returns

U.S. smaller companies have the potential to achieve higher investment returns over the long term (Fig. 1, left‑hand side). While it is true that smaller companies tend to be more volatile, they have historically outperformed their larger‑company counterparts. This makes sense as many of these companies are in the early stages of their development, are potentially undergoing rapid expansion, and yet are still small enough to deliver growth that is meaningful (Fig. 1, right‑hand side).

Historically, returns of U.S. smaller companies have been less correlated with other large segments of European‑based investors’ portfolios, compared with U.S. large‑caps. Therefore, at the total portfolio level, adding exposure to U.S. smaller companies—an asset class with historically high returns and lower correlations to other portfolio holdings— can improve the risk‑adjusted returns of a balanced portfolio (Fig. 2). That is counterintuitive to the way many investors think about the asset class. However, the evidence shows that for only limited additional risk, historical annual total returns have been greater.

Opening Quote ...these companies are in the early stages of their development, are potentially undergoing rapid expansion, and yet are still small enough to deliver growth that is meaningful. Closing Quote
Curt Organt Portfolio Manager, T. Rowe Price US Smaller Companies Equity Strategy

Greater Potential to Add Value

There is greater dispersion within the smaller‑company asset class, providing active investment managers with better opportunities to add value. Identifying mispriced stocks, such as uniquely advantaged companies, or businesses that are undervalued relative to their assets, the smaller‑company segment typically offers greater rewards as the dispersion of returns is greater than for large‑cap equities. Effectively, investors are better rewarded for picking potential winners in the small‑cap space.

At the same time, smaller companies are less covered by traditional Wall Street analysts, as indicated below (Fig. 3). If an investment team has the resources to independently meet with these underfollowed companies and assess their prospects for success, there are tremendous opportunities to add value, as many are under appreciated, or even unknown, by the broader investment community.

(Fig. 2) Improved Risk‑Adjusted Returns
Adding small‑/mid-cap (SMID) company exposure can improve risk‑adjusted portfolio returns
January 1999 through June 2019

 

 

Simulated past performance is not a reliable indicator of future performance. 
The information shown is hypothetical in nature and is shown for illustrative, informational purposes only. It is not intended to be investment advice or a recommendation to take any particular investment action. 
Sources: FTSE Russell (see Additional Disclosures), S&P (see Additional Disclosures), MSCI (see Additional Disclosures), and Bloomberg Index Services Limited (see Additional Disclosures). Data analysis by T. Rowe Price. Balanced portfolio = 30% European Equities, 15% World ex‑Europe, 15% S&P 500, and 40% Euro Bonds.

 

Opening Quote With superior growth potential, smaller companies can also provide diversification, as the drivers of performance tend to be different from those of larger companies. Closing Quote
Curt Organt Portfolio Manager, T. Rowe Price US Smaller Companies Equity Strategy

(Fig. 3) Where Active Investing Can Make a Real Difference 
The under‑researched, less efficient nature of the small‑cap segment creates opportunities.
As of June 30, 2019.
Source: Bank of America Merrill Lynch.
 

We believe there are compelling reasons for maintaining a long‑term, strategic allocation to U.S. smaller companies. While they do come with risks and the prospect of higher volatility, consistent exposure to smaller companies as part of a balanced portfolio can add value over the long term. With superior growth potential, smaller companies can also provide diversification, as the drivers of performance tend to be different from those of larger companies. They tend to have simpler business models, with less sensitivity to macro issues or industry developments; they are typically more dependent on company specific news and developments. Finally, the U.S. market is a hugely important space for smaller companies to grow. The size of the domestic economy gives companies plenty of room to scale up and grow into. The U.S. offers a particularly supportive, pro‑business environment where entrepreneurship is esteemed, and small business success stories are championed, encouraging others to follow suit.
 

WHAT WE’RE WATCHING NEXT

While uncertainty levels have risen due to changes in China trade policy, the latest data from the National Federation of Independent Business (NFIB),2 a leading small- and mid‑cap business association, showed that small business owners’ optimism remains around historically high levels. Additionally, June 2019 marked the 19th month of consecutive small business employment growth, according to NFIB’s monthly jobs report. We continue to monitor these and other data sets for any signs of material weakness emerging in the U.S. smaller‑company segment.

1Source: FTSE Russell (see Additional Disclosures), as of July 31, 2019.

2NFIB Small Business Optimism Index, as of June 30, 2019.
 


Additional Disclosures

London Stock Exchange Group plc and its group undertakings (collectively, the “LSE Group”). © LSE Group 2019. FTSE Russell is a trading name of certain of the LSE Group companies. Russell® is a trade mark of the relevant LSE Group companies and is used by any other LSE Group company under license. All rights in the FTSE Russell indexes or data vest in the relevant LSE Group company which owns the index or the data. Neither LSE Group nor its licensors accept any liability for any errors or omissions in the indexes or data and no party may rely on any indexes or data contained in this communication. No further distribution of data from the LSE Group is permitted without the relevant LSE Group company’s express written consent. The LSE Group does not promote, sponsor or endorse the content of this communication.

The S&P 500 Index is a product of S&P Dow Jones Indices LLC, a division of S&P Global, or its affiliates (“SPDJI”), and has been licensed for use by T. Rowe Price. Standard & Poor’s® and S&P® are registered trademarks of Standard & Poor’s Financial Services LLC, a division of S&P Global (“S&P”); Dow Jones® is a registered trademark of Dow Jones Trademark Holdings LLC (“Dow Jones”). T. Rowe Price’s product is not sponsored, endorsed, sold or promoted by SPDJI, Dow Jones, S&P or their respective affiliates, and none of such parties make any representation regarding the advisability of investing in such product nor do they have any liability for any errors, omissions, or interruptions of the S&P 500 Index.

MSCI and its affiliates and third-party sources and providers (collectively, “MSCI”) makes no express or implied warranties or representations and shall have no liability whatsoever with respect to any MSCI data contained herein. The MSCI data may not be further redistributed or used as a basis for other indices or any securities or financial products. This report is not approved, reviewed, or produced by MSCI. Historical MSCI data and analysis should not be taken as an indication or guarantee of any future performance analysis, forecast or prediction. None of the MSCI data is intended to constitute investment advice or a recommendation to make (or refrain from making) any kind of investment decision and may not be relied on as such.

Bloomberg Index Services Limited. BLOOMBERG® is a trademark and service mark of Bloomberg Finance L.P. and its affiliates (collectively “Bloomberg”). BARCLAYS® is a trademark and service mark of Barclays Bank Plc (collectively with its affiliates, “Barclays”), used under license. Bloomberg or Bloomberg’s licensors, including Barclays, own all proprietary rights in the Bloomberg Barclays Indices. Neither Bloomberg nor Barclays approves or endorses this material, or guarantees the accuracy or completeness of any information herein, or makes any warranty, express or implied, as to the results to be obtained therefrom and, to the maximum extent allowed by law, neither shall have any liability or responsibility for injury or damages arising in connection therewith.



Important Information

This material is being furnished for general informational purposes only. The material does not constitute or undertake to give advice of any nature, including fiduciary investment advice, and prospective investors are recommended to seek independent legal, financial and tax advice before making any investment decision. T. Rowe Price group of companies including T. Rowe Price Associates, Inc. and/or its affiliates receive revenue from T. Rowe Price investment products and services. Past performance is not a reliable indicator of future performance. The value of an investment and any income from it can go down as well as up. Investors may get back less than the amount invested.

The material does not constitute a distribution, an offer, an invitation, a personal or general recommendation or solicitation to sell or buy any securities in any jurisdiction or to conduct any particular investment activity. The material has not been reviewed by any regulatory authority in any jurisdiction.

Information and opinions presented have been obtained or derived from sources believed to be reliable and current; however, we cannot guarantee the sources’ accuracy or completeness. There is no guarantee that any forecasts made will come to pass. The views contained herein are as of the date written and are subject to change without notice; these views may differ from those of other T. Rowe Price group companies and/or associates. Under no circumstances should the material, in whole or in part, be copied or redistributed without consent from T. Rowe Price.

The material is not intended for use by persons in jurisdictions which prohibit or restrict the distribution of the material and in certain countries the material is provided upon specific request. It is not intended for distribution to retail investors in any jurisdiction.

 

201908‑925720

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