The Death of Small Cap Equities?
Has the quality of small-cap equities declined over time?
Our friend Jeff Burton at Furey Research recently published a piece titled “The Death of Small Cap Equities,” highlighting the underperformance of small-cap stocks and the deterioration in the quality of the Russell 2000 index over the last 40 years.
What was most intriguing to us was the decline in quality over time as the percentage of unprofitable companies in the index has increased. We were curious whether this trend was sector specific and whether it also held for larger stocks and international stocks.
Our first analysis examined our favorite quality metric, gross profit/assets (GP/A), over time by sector for “small” US companies, which we define as between $400M and $4B in market cap today, or the equivalent percentile rank by market cap historically. We made the decision to exclude the health-care industry entirely given the significant proliferation of unprofitable pharma and biotech stocks, which tripled in proportion from 5% of small stocks in 1995 to 16% of stocks in 2021. We were curious whether the degradation in quality still held once we excluded this mix shift impact. The chart below shows the contribution to aggregate small-cap US GP/A by sector (e.g., IT GP/A multiplied by IT proportion of total market cap).
Figure 1: US Small-Cap Median GP/A (Contribution by Sector)
Source: Capital IQ, Verdad analysis
Most notable is the broad-based decline in quality from the early 2010s to today. The most impacted sectors include IT, consumer discretionary, and industrials.
For large-cap stocks (defined as over $10B or equivalent historical percentile by market cap), the aggregate trend of a decline in GP/A also holds, which was surprising to us. The notable exception, however, is IT, which has dramatically increased in quality, driven by the mega-cap tech stocks expanding profitability. The biggest detractors in quality among large-cap stocks have been declining GP/A for consumer staples and industrials.
Figure 2: Large-Cap Median GP/A (Contribution by Sector)
Source: Capital IQ, Verdad analysis
This trend in declining quality is most evident in the United States. When we look at Japanese or European markets, we see much more stable or even increasing signs of quality among both large and small caps. Japan, in particular, has had stable GP/A and impressively increasing ROAs over a similar time period.
Figure 3: Japan Median GP/A and ROA
Source: Capital IQ, Verdad analysis
Given this divergence in quality trends, we find it notable that US large caps trade at a premium to the rest of the world, while the median US small cap stock trades in line with Europe, and at a premium to Japan. The median GP/A and EV/EBITDA for each region and size group is shown below in Figures 4 and 5.
Figure 4: Median GP/A by Region x Size
Source: Capital IQ, Verdad analysis
Figure 5: Median EV/EBITDA by Region x Size
Source: Capital IQ, Verdad analysis
As the tables above show, small caps currently trade at a 40% discount relative to large caps in the US, so its plausible the decline in small cap quality is reflected in lower multiples. But this still leaves the question of why US small caps trade in line with Europe and at a premium to Japan despite lower GP/A.
The US valuation premium does not appear to be explained by higher revenue growth in the US. As of October 31, 2023, median LTM revenue growth in the US was 5%, versus 9% for Europe and 11% for Japan.
Anyone familiar with our research should know that we are believers in small-cap equities. While we think “the death of small-cap equities” is greatly exaggerated, we do believe in looking outside of the US for higher quality at a lower price.