asset allocation | december 11, 2023
How attractive are U.S. small-cap stocks?
Cheap valuations and an improving outlook favor small-caps, but high rates are problematic.
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How attractive are U.S. small-cap stocks?
U.S. small-caps are very cheap by historical standards. As of November 21, the forward P/E for the S&P 600 Index stood at 12.6, a level well below historical norms for the index. In fact, since the turn of the millennium, we have only seen the S&P 600 dip below 13 twice. Once was in 2008 during the global financial crisis and the other was in 2011 when sovereign debt concerns weighed heavily on stock market valuations across the globe.
In addition to low valuations, small-cap stocks offer an improving earnings outlook, as forward earnings estimates have recently stabilized.
Small-cap earnings have been on a bit of a roller coaster ride in the wake of the COVID-19 pandemic. From January 2020 to May 2020, forward earnings estimates fell by an astonishing 45%. But over the subsequent two years, estimates skyrocketed, cumulatively increasing by 212% as the pandemic shutdown was replaced by a robust reopening of the U.S. economy. However, that period of prosperity was replaced by yet another downturn—one that looked as if it could turn ugly earlier this year.
Fortunately, the U.S. economy has proven more resilient than expected in 2023, which has translated into earnings estimates stabilizing in June and July and subsequently showing signs of upward momentum as we enter 2024.
Unfortunately for small-cap investors, cheap valuations and an improving earnings outlook have recently been overshadowed by concerns about higher interest rates, which pose a notable challenge to many small-cap companies for three primary reasons:
1. Higher leverage. Small-cap companies hold higher debt burdens than large-caps, as illustrated by a comparison of net debt-to-EBITDA ratios. Small-cap net debt is more than 4 times as large as EBITDA, while the large-cap ratio is only 1.42.
2. Thinner margins. While operating margins for small-caps have been gradually increasing over the last 20 years, they stand well below those of large-caps, at 13% versus 21%. This means that as interest costs increase, small-caps have less of a buffer before profit margins turn negative.
3. Nearer-term maturities. Sixty-four percent of the outstanding debt for small-cap companies matures within the next five years versus only 44% for large-caps. This means that interest costs will increase more quickly for small-caps, as company bonds that were issued when interest rates were at extremely low levels will need to be refinanced at higher rates sooner.
In conclusion, U.S. small-cap stocks offer a compelling combination of attractive valuations and an improving earnings outlook. As a result, our Asset Allocation Committee currently holds an overweight position to U.S. small-cap equities.
However, small-cap companies are likely to prove more sensitive to higher interest rates than large-cap companies. For this reason, we believe it is preferable to invest in this asset class via actively managed portfolios with a higher-quality bias.
Key Insights
U.S. small-cap stocks are attractive, given cheap valuations and an improving earnings outlook.
However, higher interest rates pose challenges to smaller companies due to higher leverage, thinner margins, and more debt with near-term maturities.
Relative to history, U.S. small-cap stocks are cheap. The S&P 600 Index’s forward price-to-earnings (P/E) ratio was 12.6 as of November 21, 2023. This ratio had only dipped below 13 twice since the turn of the millennium—in 2008, during the global financial crisis, and in 2011, when sovereign debt concerns weighed heavily on global stock valuations (Figure 1).
In addition to low valuations, an improving earnings outlook may favor small-cap stocks. Despite recession fears, the U.S. economy has proven to be more resilient than expected in 2023. Forward earnings estimates stabilized in June and July, and there are signs of upward momentum as we enter 2024.
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U.S. small-cap valuations are at historically low levels
(Fig. 1) S&P 600 Forward P/E Ratio
January 1, 2000, through November 21, 2023.
Actual outcomes may differ materially from forward estimates.
Sources: T. Rowe Price analysis using data from FactSet Research Systems Inc. All rights reserved. S&P 600 Index. See Additional Disclosures.
However, concerns about higher interest rates pose a notable challenge for U.S. small-cap stocks. A comparison of net debt1 to EBITDA2 ratios shows that small-cap companies typically have higher debt burdens than large-cap companies (Figure 2). Operating margins for small companies also stand well below those of large companies. This means that as interest costs increase, small-cap companies have less of a buffer before profit margins turn negative.
Small-cap companies have higher debt burdens
(Fig. 2) Net debt to EBITBA
January 2009 through October 2023.
Past results are not a reliable indicator of future results.
Sources: Bloomberg Finance L.P., S&P 500 and S&P 600 indices. See Additional Disclosures.
*EBITDA = earnings before interest, taxes, depreciation, and amortization.
Further, data also show that smaller companies have more debt that will mature within the next five years than large companies.3 Interest costs for small-cap companies are, therefore, likely to increase more quickly, as company bonds will need to be refinanced at higher rates sooner.
Overall, U.S. small-cap stocks offer attractive valuations and an improving earnings outlook, but they are also more sensitive to higher interest rates than large-cap companies. As a result, our Asset Allocation Committee currently holds an overweight position to U.S. small-cap equities. We believe it is prudent to invest in this asset class via actively managed portfolios with a higher quality bias.
1Net debt shows how much cash would remain if all debts were paid off and if a company has enough liquidity to meet its debt obligations.
2EBITDA = earnings before interest, taxes, depreciation, and amortization.
3As of October 26, 2023. Source: T. Rowe Price analysis of companies in the S&P 500 Index and the S&P 600 Index using data from Bloomberg Finance L.P.
Additional Disclosures
CFA® and Chartered Financial Analyst® are registered trademarks owned by CFA Institute.
The S&P 500 Index and the S&P 600 Index are products 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 Products are not sponsored, endorsed, sold or promoted by SPDJI, Dow Jones, S&P, their respective affiliates, and none of such parties make any representation regarding the advisability of investing in such product(s) nor do they have any liability for any errors, omissions, or interruptions of the S&P 500 Index and the S&P 600 Index.
Important Information
This material is provided for informational purposes only and is not intended to be investment advice or a recommendation to take any particular investment action.
The views contained herein are those of the authors as of December 2023 and are subject to change without notice; these views may differ from those of other T. Rowe Price associates.
This information is not intended to reflect a current or past recommendation concerning investments, investment strategies, or account types, advice of any kind, or a solicitation of an offer to buy or sell any securities or investment services. The opinions and commentary provided do not take into account the investment objectives or financial situation of any particular investor or class of investor. Please consider your own circumstances before making an investment decision.
Information contained herein is based upon sources we consider to be reliable; we do not, however, guarantee its accuracy.
Past performance is not a reliable indicator of future performance. All investments are subject to market risk, including the possible loss of principal. Small-cap stocks have generally been more volatile in price than the large-cap stocks. All charts and tables are shown for illustrative purposes only. Index data is for illustrative purposes only and is not indicative of any specific investment. Investors cannot invest directly in an index.
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