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IPE special report May 2018

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Todd Ruppert of T Rowe Price believes that European investors should take a closer look at US smaller companies
Last year in this space, we made the case for European pension plans to consider small- and mid-cap US equities as a means to diversify their US equity allocations and to capture broader returns from the US equity market. As we have spoken with more and more institutional investorsduring the past year, we have found it apparent that recent surveys showing changes in European investment practices have indeed captured a genuine trend. Institutional investors are moving away from the traditional balanced portfolio model of investment, and are actively considering many segments of the markets for independent “specialist” allocations.
This is a beneficial trend. While large-cap, “blue chip” stocks have fueled much of the astonishing performance of the US equity market over the past five years, the volatile behaviour of the market in 1999 has made investors ever more conscious of the high valuation of large growth stocks. For the first time in several years, both value stocks and smaller company stocks have experienced long stretches of outperformance relative to the S&P 500 Index, underlining the basic axiom that no sector outperforms forever. European investors who have allocated their US exposure solely to large-cap equities, particularly through S&P 500 indexed mandates, may be exposed to greater risk than they anticipated.
Even more importantly, by focusing on one narrow sector of the US equity market, investors may incur the opportunity cost of foregoing returns that could otherwise be earned. While it is true that smaller-capitalisation stocks are, in themselves, more volatile than their large-cap counterparts, especially in the short term, it is also true that, over time, periods of strength in the small- and mid-cap markets tend to alternate with periods of strength in the large-cap market. By allocating assets among small-, mid-, and large-cap stocks, the cyclicality of returns within a US allocation can be smoothed without incurring an unacceptable level of risk. And, given the recent strong performance of smaller companies, we believe the time is opportune to reiterate the benefits of investing in these stocks.
Why look at smaller companies? In a US equity market that contains over 7,000 listed stocks, only 276 companies qualify as “large-cap” – that is, have a market capitalisation of more than $7.5 billion. What about the other 96% of companies?
These small- and mid-cap companies, for the most part, focus on the US domestic market for their revenues and profits. Smaller companies are also the drivers of most US job growth, and hence are a major component of domestic consumption. As such, small- and mid-cap companies are much closer to being “pure plays” on the US economy than large-caps, which are often multinational in scope. Yet smaller-company stocks account for barely 25% of total US market capitalisation. Why should so small a percentage of the market command an investor’s attention?
In a word, performance. Many well-managed smaller companies have better internal growth prospects than large companies in mature industries, and thus command higher price-to-earnings multiples once their ability to grow has been demonstrated. It is also worth pointing out that, since our report last year, the total number of companies on the major US stock exchanges has dropped by 261, with almost all of the decrease occurring in the small- and mid-cap range. Total market capitalisation, however, has jumped by $1,482bn. This is indicative of another driver of small-cap outperformance – mergers and acquisitions. As industry consolidation occurs, smaller companies are frequently taken over for significant price premiums.
Historical research bears out the potential for small-cap outperformance. The historical case for investing in smaller company stocks was succinctly made by Claudia Mott of Prudential Securities, in her analysis of data from the University of Chicago Center for Research in Securities Prices. Since Mott’s original study in the early 1990s, T Rowe Price has continued to update the data. The results show that small-cap stocks have returned an average of 11.9% a year since 1926, versus 10.65% for large-caps. Compounded over time, that 125 basis points of spread becomes a tremendous performance advantage.
The Small-Cap Cycle: As noted, small-cap performance tends to occur in cycles that counterbalance periods of outperformance by large-cap equities. This point is best made by looking at actual investing experience. Because the most widely-used benchmark of small-cap performance, the Russell 2000 Index, has only been in existence since 1978, those who are interested in longer-term small-cap performance have traditionally looked to the T Rowe Price New Horizons Fund for empirical data.
The New Horizon Fund, which was established in 1960, is a growth-oriented small-cap fund that is actively managed on the basis of fundamental research. Over time, the price to earnings ratios for the stocks in New Horizons have typically ranged from one to two times the ratios of large-cap stocks (see Figure 1). Periods of rising relative P/E ratios correspond to periods when small-cap stocks outperformed large-caps; conversely, when relative P/Es have dropped, small-caps have underperformed.
Table 1 shows the magnitude of these cycles in terms of total return performance. Performance spreads between the two asset categories have at times exceeded 250 percentage points. Such huge cyclical disparities highlight the need to be invested at both ends of the capitalisation spectrum. It is also worth noting that the three widest spreads over the past 39 years have all favoured small-cap stocks.
A crucial point to notice is that the beginnings of the four major cycles of smaller company outperformance – in 1964, 1970, 1976 and 1990 – have coincided with periods when the P/E ratios of these companies approached parity with those of large-caps (1.0 on the chart). Now consider the most recent data: in the first quarter of 1999, the relative P/E of small-cap stocks bottomed at 0.78 – the lowest relative P/E since New Horizons was established. In subsequent quarters, however, the ratio has risen steadily, reaching 1.02 at the end of the third quarter. This turn in our indicator tells us that we may be poised to begin a new cycle of smaller company outperformance.
And, in fact, small-cap companies have performed well on a relative basis in the second and third quarters of 1999. In the second quarter, the Russell 2000 Index returned 15.55%, versus 7.05% for the S&P 500 Index. In the difficult third quarter, when typically one would have expected smaller companies to demonstrate more volatility than larger ones, the Russell 2000 held its own, losing 6.32% versus an S&P 500 loss of 6.24%.
When viewed over longer periods, too, the gap has been closing. Table 2 shows rolling 12-month performance for the past four quarters. During the first quarter of 1999, when our P/E indicator was at its bottom, the 12-month performance spread between the Russell 2000 and the S&P 500 also bottomed. The small-cap index was 34.72 percentage points behind the large-cap benchmark. Since then, the gap has narrowed dramatically. As of 30 September 1999, the Russell 2000 had made up nearly 26 percentage points of the deficit in just two quarters.
Where to start: Successful smaller company investing is based upon recognition of solid growth opportunities, and management of the inherently greater risk that such opportunities carry. The truism most often quoted for small-cap equities is simple and stark – “Companies either grow up or blow up”. The key to a successful portfolio is individual company research.
A major reason why small-cap equities tend to outperform large-cap equities over the long term is because the immense and shifting market of smaller companies is so inefficient relative to the large-cap universe. Large companies are the focus not only of regulatory scrutiny, but of analytical and public scrutiny as well. No event is overlooked and information is instantly disseminated.
While smaller publicly-traded companies in the US are held to the same high reporting standard as the large companies, sheer numbers ensure that not every company receives a similar level of analytical scrutiny. Companies under a billion dollars in market capitalisation, for example, average three Wall Street estimates, as compared to 20 or more estimates for the typical large-cap company (according to I/B/E/S data). Many companies have no Wall Street coverage whatsoever. The information is there, but often no one is looking.
It takes a significant commitment of firm resources to assemble a credible and effective research team for smaller companies. Experience and a strong network of contacts count for a lot in this area. A hands-on approach – visiting companies, touring their operations, meeting with both senior managers and workers on the line, talking with suppliers and competitors, and participating in conferences and seminars where industry trends can be spotted – is critical for uncovering the hidden value that marks a small-cap winner. Likewise, experienced judgement based on solid information becomes an investor’s best hedge against risk.
In short, a successful smaller-company research effort requires being there. The lack of an analytical presence in the US is perhaps the biggest reason why European-based asset managers have avoided investing their clients’ money in US small- and mid-cap equities. An investment manager who can support a comprehensive and dedicated small-cap research effort is best placed for achieving outperformance over the long term.
The Case for Mid-Caps: Even when a manager can offer solid smaller-company research and an experienced investment team, however, the volatility of small-cap stocks can be too high for some investors to tolerate. The Prudential/University of Chicago data which demonstrated small-cap outperformance also showed that small-cap stocks had a standard deviation of 30.76%, versus 19.16% for large-caps. Additionally, some small-cap stocks are very thinly traded. This inefficient market is one of the reasons why so much opportunity can be found in the small-cap area, but it also means that some investments can be relatively illiquid.
As the investment community has sought a systematic way to participate in the growth potential of smaller companies while reducing the inherent risk of small-caps, a focus on companies with intermediate market capitalisations has developed. Mid-cap equities are now tracked by several recognised indices, most notably the S&P MidCap 400 Index (established in 1991).
Mid-cap equities have a market capitalisation roughly between $1 billion and $7.5 billion. Many of these companies have “grown up” through the small-cap ranks, and therefore have significant operating histories and proven business concepts. Mid-caps also tend to have higher trading volumes, making them more liquid investments. The mid-cap market is thus more efficient than that of small-caps, but is still less efficient than that of large-caps, leaving substantial room for opportunity.
The Prudential/University of Chicago study shows that, over the long term, mid-cap equities have outperformed large-caps by about 90 basis points per year, capturing a substantial portion of the small-cap premium. Yet volatility, at a standard deviation of about 25%, has been substantially less than the small-cap average.
It is this kind of performance that has created the rapid acceptance of the mid-cap asset class among investors and consultants alike. It also makes mid-caps an attractive way to participate in US smaller-company investment for those European investors who are more risk-averse.
Why Now? The Russell 2000 Index has risen 40% from its recent low on October 8 1998. Is there still opportunity to be found in the small- and mid-cap markets? Based on the T Rowe Price New Horizons Fund relative P/E indicator, there remains plenty of room for relative valuation to rise. In addition, there are several other factors that could contribute towards the developing trend of strong small- and mid-cap performance. Among them:
q US inflation remains low while economic growth remains strong—small- and mid-cap companies benefit in a healthy domestic economy.
q Earnings growth also continues—I/B/E/S forecasts place smaller- company growth significantly ahead of large-cap growth in coming quarters.
q Company share repurchase activity is at record levels—not only is this a sign that corporate managements have a high level of confidence in their companies, but also a decreasing supply of shares creates stronger demand, and thus higher prices, for shares that remain outstanding.
In short, many technical and fundamental indicators show that the small- and mid-cap equity markets may be embarking on a cycle of outperformance. It is not too late for European institutional investors to take a second look at the opportunities to be found among smaller US stocks.
Todd Ruppert is managing director of T Rowe Price Associates

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