A turnaround in fortunes for beleaguered small caps

After nearly three years of “uncharacteristic underperformance”, global small caps stocks are expected to rebound appreciably this year, outperforming large-cap earnings growth in most regions, according to global investment firm American Century Investments (ACI).

Small cap stocks, alongside other longer-duration risk assets, have faced considerable “headwinds” over the last three years, driven by concerns over rising inflation, correspondent interest rate rises, and an overall slowing in economic growth, according to ACI’s Trevor Gurwich, senior portfolio manager, and Jim Shore, senior client portfolio manager.

“The steady climb in the US 10-year Treasury yield since the end of 2021 has also worked against small caps, especially growth-oriented stocks,” the pair noted.

As a result, since 2021 and continuing into last year, small caps have underperformed large caps “by a wide margin”, the pair added, and particularly so in the US – considered an exceptional circumstance, given the more than 20-year record of small caps outperforming large caps.

Global small caps are set to benefit this year with a forecast easing of inflation pressures and a correspondent pause in central bank rate hikes, providing a “tailwind” for growth in the sector.

This, according to pair, will allow investors to refocus on earnings growth as the key driver of stock prices.

Off the back of these trying economic conditions, global small cap valuations have today hit a historical low point relative to their large-cap peers, creating a compelling proposition for investors.

As economic conditions become increasingly favourable for small caps, both Gurwich and Shore believe that, based on consensus earnings per share, profits for these businesses will grow faster than large-cap profits this year in most regions.

After a two-year lull in merger and acquisition activity, which saw M&A movements drop to near 25-year lows, the pair at ACI predicts there will be “pent-up demand for deals by acquirers”, translating to favourable outcomes for small cap investors – a sector that is often a key beneficiary of such activity.

“We may see a positive turn in [M&A] activity in 2024 as financing visibility improves and larger firms seek to boost organic growth rates,” the pair wrote.

Small cap sectors set to gain in 2024

Split by sector, ACI predicts healthy gains can be made in small caps stocks based within the travel, logistics software and cybersecurity, and nearshoring and infrastructure industries.

For instance, a rise in travel-related spending by consumers may benefit consumer discretionary stocks, with ACI singling out global luggage manufacturer Samsonite as a likely strong performer in 2024.

“Improving earnings has also allowed the company to reduce its debt significantly and strengthen its balance sheet,” Gurwich and Shore wrote. “Despite consistent positive earnings revisions, Samsonite’s valuation has contracted and now trades at only 10 [times] forward earnings per share.”

Cybersecurity-related holdings, including Tenable, are also likely to prove beneficiaries of innovations in and the commercialisation of emerging technologies, including artificial intelligence (AI).

“Adopting AI will likely lead to a greater frequency and higher sophistication of cyberattacks, requiring companies to spend more on protecting their networks.”

ACI notes that companies tied to nearshoring and infrastructure spending will achieve notable growth, including Canada-based Stantec, a global leader in sustainable engineering and environmental consulting.