The Death of Small Caps

This article is a translation of Chris Satterthwaite’s The Death of Small Cap Equities?, with the author’s own commentary added.

Jeff Burton of Furey Research recently published a piece titled “The Death of Small Cap Equities,” highlighting the poor performance of small caps over the past 40 years and the qualitative deterioration of the Russell 2000 Index.

What I found most interesting was the argument that the quality of the index has declined over time because the share of unprofitable companies in the index has increased. This made me wonder whether this trend is confined to specific sectors, and whether it also applies to large caps and non-U.S. equities.

In the first analysis, we examine the quality metric gross profit to assets (GP/A) over time by sector for U.S. “small-cap” companies, defined as those with a current market cap between $400 million and $4 billion, or based on historical market-cap percentile ranks. Given that the share of low-profit pharmaceutical and biotechnology stocks has tripled from 5% of small caps in 1995 to 16% in 2021, we decided to exclude healthcare entirely. We wanted to see whether quality deterioration persists even after stripping out the impact of this mix shift. The chart below shows the sector-level contribution to GP/A (gross profit to assets) for U.S. small caps.

The most notable finding is that the overall quality of small caps has declined from the early 2010s to today. The sectors that appear to have been hit the hardest are IT, consumer discretionary, and industrials.

It was also striking to see that for large caps (defined as companies with a market cap of $10 billion or more, or the equivalent historical percentile), the downward trend in gross profit to assets (GP/A) has persisted as well. A notable exception is IT, where the expanding profitability of mega-cap tech stocks has significantly improved the overall earnings quality of large caps. Among large caps, the biggest drag on quality has been the decline in GP/A for consumer staples and industrials.

This deterioration in quality is most pronounced in the United States. Looking at Japan and Europe, both large and small caps show much more stable, or even improving, trends. Japan in particular has maintained a stable GP/A and has posted an impressive increase in ROA over a similar period.

Given these differences in quality trends, it is notable that U.S. large caps trade at a premium to those in other regions, while the median valuation of U.S. small caps is similar to Europe and at a premium to Japan. Exhibits 4 and 5 below show the median GP/A and EV/EBITDA by region and size bucket.

As the tables above show, U.S. small caps currently trade at a roughly 40% discount to large caps, so it is plausible that the qualitative deterioration of small caps is reflected in lower multiples. Still, it remains puzzling that U.S. small caps, despite their low price-to-earnings ratios, trade at similar levels to Europe and at a premium to Japan.

The U.S. valuation premium does not appear to be explained by higher revenue growth. As of October 31, 2023, median LTM (last twelve months) revenue growth was 5% in the U.S., compared with 9% in Europe and 11% in Japan.

Readers who have followed Verdad’s research over time will know that they are staunch believers in small caps. While I think talk of the “death of small caps” is greatly exaggerated, I will close by saying that we believe investors can find higher quality at lower prices outside the United States.

All charts used in this article are sourced from Capital IQ and Verdad analysis, as cited in the original document.