The ‘magnificent seven’ dominated markets last year: why smaller companies could boost profitability in 2024

Investing in small cap stocks when economic conditions are difficult can be uncomfortable.

However, history tells us that now may be a good time to start considering whether these companies deserve a place within a diversified portfolio.

We analyzed data from the last five decades to get some insights from history to test our thoughts.

The stock market stares into the crystal ball

One of the best leading indicators is the stock market itself.

This is because investors are not only concerned about today’s headlines, but also how the future will unfold.

Investors anticipate how the future might develop and then trade the company’s stock accordingly, driving the stock price up or down in advance of actual news.

This means, for example, that when a company announces how much its sales have increased, the stock price may not change that day if the company grew by the amount investors expected.

What most tends to make the stock price move that day is when the announcement is above or below the expectations that were formed beforehand.

Small cap stocks are no different in this regard, and this can be a clue to what lies ahead for them.

What the market expects

Over the past year, the fortunes of large and small companies around the world have diverged.

This was primarily due to the so-called seven largest US companies, but also reflects the risks associated with owning smaller companies, which are more sensitive to the economic cycle.

There are a few reasons why investors may prefer larger companies in the later phase of an investment cycle.

Larger companies typically have multiple research analysts interpreting their performance, which reduces uncertainty, generally have easier access to financing in times of need, and have multiple diversified products to sell, which helps stabilize their cash flows. cash.

This makes larger companies an attractive offering in times of economic slowdown. But, as the performance chart above shows, the market may have already recognized this.

The key question is whether small-cap stocks can have enough “bad expectations” in their price; we could turn to history to guide us.

We’ve analyzed data going back to 1980 to find out. We study how small- and large-cap stock prices behave during each phase of the investment cycle.

The table below shows that investing in small caps when the environment is uncomfortable has generated good results, when investors take a long-term approach.

While the average returns of small- and large-cap stocks in expansion and downturn phases have been similar over this period, small-cap stocks have generated, on average, more than double the returns of large-caps during the recession and recovery phases.

However, no two cycles are exactly alike, and the current cycle may provide its own clues as to what lies ahead for investors.

Positioning for the next phase of the economic cycle

While it is always a challenge to identify exact turning points in any economic cycle, we are starting to see evidence that we are closer to an inflection point than in the past.

Our study provides evidence that you tend to be rewarded for anticipating when smaller companies will perform well again.

We are starting to find some attractive opportunities among small caps, particularly in regions that have already experienced the impact of higher interest rates. When markets recognize that a new phase in the investment cycle has begun, stock prices often change sharply and suddenly.

While it is important to note that investment performance may suffer if the allocation to smaller companies is increased too early, it is prudent to ensure that you have a seat at the table to avoid missing out on the performance of small cap companies, which often comes suddenly.

We have identified an opportunity in the United States, where the fortunes of all companies outside the ‘Magnificent 7’ have faced headwinds, and this has been more pronounced for smaller companies.

For example, smaller companies (as measured by the S&P 600) have seen their profits decline by 16.6 and 14.4 percent in the second and third quarters of 2023, indicating that larger companies may little ones have already experienced their intracycle pain.

This pain is already being reflected in valuation levels that are approaching half those of their larger counterparts.

To capture this vision, we have implemented our vision by allocating funds to a Fisher Investment Fund. We believe the fund offers a unique approach to small and medium-sized companies by focusing on top-down macroeconomic, sentiment and political factors.

Their philosophy promotes a flexible approach, not tied to a style or biased to a fundamental process. We view this as a positive attribute as we navigate a potential transition phase of the global economy.

Outside the US we have been more selective. In emerging markets we previously had a position in smaller companies, but we have closed it at a profit.

Robert Starkey is a portfolio manager at Schroder Investment Solutions