Since late November, we have been positive on small cap stocks as an economic recovery play. Eight months later, this investment thesis has continued to pay off for long-term investors. Year-to-date, small cap stocks globally have significantly outperformed their large cap peers.
Our thesis for small cap outperformance was and continues to be based on the following:
- We are at the start of a long-term economic cycle.
- A combination of low-interest rates, government spending and pent-up consumer demand has led to a strong economic recovery that should last for years.
- A reminder that after the 2008-2009 Great Recession, the global stock markets experienced their longest bull market ever, at approximately 11 years. Although there were the eventual ‘bumps in the road’ for investors during this time, as markets went through corrective phases, the long-term trend was up. The after COVID global economic recovery is so far following the same pattern, with ultra-low interest rates globally, government spending and strong consumer demand resulting in a global inventory restocking cycle.
- Small Cap companies have more leverage to an economic recovery.
- Small cap companies typically have more revenue exposure to the domestic economy, therefore they were the hardest hit during the national lockdowns. As a result, we expected their profit margins to bounce back stronger on a recovery, as COVID restrictions started to ease.
- Rising profits margins mean investors that are seeking capital appreciation will pay a higher price for these stocks for their long-term growth potential.
- Valuation discount relative to large cap companies
- Since March 2020, small cap companies have been trading at a significant discount to their large cap peers, as investors fled to the safety of larger companies to weather the economic uncertainty caused by COVID.
- Although this discount has narrowed, many high-quality companies in our Fund are trading at a discount, with better investment characteristics and earnings growth prospects than large cap companies.
- Historical Evidence
- Using U.S. small cap performance data since 1925, we know that small cap stocks have an outperform cycle relative to large cap companies. As shown on the chart below, when the blue line is increasing small cap stocks are outperforming.
U.S. Small Caps Relative to Large Caps Since 1925 (TR)
Performance based on ibbotson SC TR index from 1925 to 1978 and Russell 2000 (TR) thereafter. Source: Scotiabank GBM Portfolio Strategy, Morning star, Shiler
- Since 1925, there have been five cycles of outperformance, lasting from 6 to 20 years, with an average of 11 years and a median of 10 years. Given that every economic cycle is slightly different based on economic and political factors at that time, we cannot automatically assume that outperformance will last 10-11 years this time, however, we can with a high degree of confidence believe that a minimum of 6 years is possible.
- The Bottom Line
- We believe investors should have exposure to small cap stocks in their portfolios as part of their overall asset mix. The Matco Small Cap Fund year-to-date as of June 22nd is up 16% and up 45% over the last year.
- The Fund is trading at a significant valuation discount relative to large cap companies, has a higher dividend yield at 4% than market indices and has better earnings growth prospects.
If you are not sure about how much exposure you should have to small cap stocks or would like more information about the Matco Small Cap Fund, please reach out to me.
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Anil Tahiliani, CFA, MBA
Vice President & Portfolio Manager