The month of November has started well for small stock exchange funds. Worldwide, the MSCI World Small Cap index is up 3%. The European variant even has a profit of almost 5%. Is that the start of something beautiful? Will years of underperformance finally come to an end?
Morningstar analyst Sarah Hansen has a good feeling about it, after visiting various fund managers.
According to her, the underperformance is largely related to three factors: interest rates, the direction of the economy and an exaggerated orientation of institutional investors towards large shares.
If interest rates fall and the economy improves, this will be beneficial for small caps. That sounds logical, but doesn’t that apply to all companies?
Yes, that is true, says Hansen, but the dimensions of small caps are of a completely different order. Small stock exchange funds are much more sensitive to shifts in interest rates because they rely more on debt capital.
They are often young, fast-growing companies that make little or no profit and have to constantly borrow money or issue new shares to finance growth.
Rising interest rates therefore have a direct and major effect on costs. If things are not going well from a business economic perspective, they often have to pay more for loans than large, strong large caps due to their often lower creditworthiness. This is of course detrimental to the stock prices of small caps.
A second factor that affects small caps more than large caps is the economic outlook.
Historically, there is a clear correlation between the stock market performance of small caps and the economic cycle. When the economy is doing better, small caps are often the first to benefit, but when a recession threatens, the opposite happens.
Since investors have been living in fear of a recession since the Russian attack on Ukraine and interest rates have risen due to high inflation, it is not surprising that small caps are performing worse than large caps.
The advantage is that this has led to quite low valuations for small caps. According to Morningstar, the average share price of small caps is 0.78 of their fair value. For American large caps this is 0.93.
In principle, the further the share price is below the fair value (<1), the greater the undervaluation.
Sentiment changes with interest rates
However, the most important thing in favor of small caps is not the valuation, but the changing sentiment around interest rates.
In October, analysts still had a “higher-for-longer” interest rate feeling, especially in the US, which translated into a 10-year yield on American treasuries of around 5%.
Analysts have now changed their opinion. Many of them now believe that the Fed will not raise rates further, and that there may be room for cuts early next year. The US 10-year interest rate has therefore fallen to 4.6%, which is positive for small caps.
The downside is that interest rates have mainly fallen because analysts have become more gloomy about the economy in 2024, and that is therefore unfavorable for small caps.
Keep powder dry
Some fund managers are therefore keeping their powder dry with small caps for the time being until the threat of recession has passed.
On balance, however, Sarah Hansen mainly sees bright spots. The fear of recession is already largely reflected in the prices, and interest rates appear to be over the top.
Suppose the Fed lowers interest rates next year and a recession is avoided, then this can hardly be anything but beneficial for small caps. Especially if institutional investors pay more attention to this market segment.
The Editorial staff of IEXProfs consists of several journalists. The information in this article is not intended as professional investment advice or as a recommendation to make certain investments. .