Tim Courtney, Chief Investment Officer
A constant theme in U.S. markets in 2023 has been the dominance of a select group of Big Tech companies — stocks like Amazon, Apple, Microsoft, Tesla and Nvidia. Investors have remained focused on these mega-cap names, resulting in an unusual level of market concentration from a relatively small number of stocks.
The market has been obsessed with these and other tech/AI companies and has been willing to pay higher and higher prices for many of them. Meanwhile, much of the rest of the stock universe has been overlooked, specifically U.S. small and mid-cap stocks, which are currently trading at a substantial discount — approximately 30% below their long-term average valuations.1
For comparison, consider the Russell 1000 Growth Index, an index that contains most of the AI and tech stocks that have dominated 2023. The index is currently trading at a P/E ratio of about 32, roughly 40% higher than its historical average of 23.2 In contrast, the S&P SmallCap 600 Value Index is trading at a P/E ratio of approximately 12, about 25% cheaper than its historical average of around 17.3
But what has led to such a divergence in pricing between the large and small cap universe? There are a couple of key factors at play.
First, there's a sentiment in the market that we might be headed for a recession, driven by rising interest rates that will slow growth and start to damage certain companies and households. Historically, smaller companies tend to feel the impact of economic slowdowns sooner and more intensely than their larger counterparts. Consequently, to at least some degree the market is seeking refuge (and is willing to pay a big insurance premium) in what it perceives as the safe haven with these large names.
However, it's worth noting that many of these mid-sized and smaller companies are already priced as if a recession is underway. This significant discount suggests that long-term investors might find current prices rewarding in the sectors of the market that are already priced for some bad news.
Secondly, there's optimism in the market that interest rates may decline in the future. Investors are hopeful that a decrease in interest rates would benefit all companies, but would especially help the valuations of large technology companies which took a hit in 2022 as higher interest rates adversely impacted their valuations. The market is probably anticipating these lower rates and factoring them into higher valuations for the mega caps. This would also explain part of the huge pricing gap between large and small-cap stocks.
Of course, lower interest rates would generally benefit all companies by reducing borrowing costs and increasing capital availability. If rates do fall, the benefits would eventually flow to mid and smaller companies.
History suggests that productive assets that are discounted and ignored by markets often turn out to perform well in future years. Current price is a large determinant of future expected returns. Just as we prefer lower prices as consumers, we prefer to buy at lower prices as investors, all things being equal. Small and mid-cap stocks have that as an advantage and tailwind for future years, while some of the largest and most expensive stocks today have a headwind in their high prices. If you have any questions, please reach out to your Exencial advisor.
- Barron’s (10/11/23) – Small-Cap Funds Are More Promising Than They Have Been in Years. Here Are the Ones to Buy.
- FTSE Russell (10/31/23) - Russell 1000 Growth Index Fact Sheet
- S&P Global (10/31/23) - S&P SmallCap 600 Value Index Fact Sheet
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The Russell 1000® Growth Index measures the performance of the large-cap growth segment of the US equity universe. It includes those Russell 1000® companies with higher price-to-book ratios and higher forecasted growth values. The Russell 1000® Growth Index is constructed to provide a comprehensive and unbiased barometer for the large-cap growth segment. The index is completely reconstituted annually to ensure new and growing equities are included and that the represented companies continue to reflect growth characteristics.
The S&P SmallCap 600 Value Index is a stock market index established by S&P Global Ratings in 1995. The capitalization-weighted index tracks small-cap U.S. equities. The index measures value stocks using three factors: the ratios of book value, earnings and sales to price. To be included in the index, a stock must have a total market capitalization that ranges from $850 million to $5.2 billion.