- Quality small-cap stocks are currently undervalued and overlooked, similar to the aftermath of the dot-com bubble in 2000.
- The shift of big pools of capital from public markets to private markets has led to a decline in demand for small-cap stocks and a decrease in valuations.
- Investors are primarily chasing performance from mega-cap tech stocks, causing small caps to be neglected.
- Macro factors such as rising interest rates and smaller companies’ debt dynamics have also impacted small-cap valuations.
- Potential catalysts for upside in small-cap stocks include a recovery in market sentiment, M&A activity, and the historical small-cap premium.
The legendary musician Prince exhorted us to “Party Like It’s 1999,” but as a small-cap stock investor, it may be more relevant to look back at the year 2000. During that time, the NASDAQ had reached its peak and subsequently experienced a significant decline, leading to the dot-com bubble. Many former high-flying tech stocks lost a substantial amount of value. However, for some investors, this period presented an opportunity to acquire positions in quality companies at discounted prices.
Similarly, today’s small-cap stocks are facing challenges. They are unloved and unwanted in the market’s current party, which has been dominated by mega-cap tech stocks, particularly those associated with artificial intelligence (AI). The parallels between the AI mania and the dot-com era are hard to ignore. Just like companies with internet potential were market darlings in the past, AI-related stocks are receiving significant attention now. However, history has shown that such trends don’t always end well. Nevertheless, the current situation presents an opportunity for selective stock picking, especially in Canadian small-cap technology stocks.
There are several reasons behind the current low valuations of small-cap stocks. Firstly, large institutional investors, such as pension funds, are increasingly allocating their capital to private markets. Private equity and venture capital funds provide diversification benefits and the potential for alpha generation. This shift in capital allocation away from small-cap public companies has led to a decline in demand for small-cap stocks and subsequently lower valuations.
Secondly, investors have been primarily chasing the performance of mega-cap tech stocks, such as Nvidia, Microsoft, Amazon, Apple, Alphabet, Tesla, and Meta. These stocks have been driving recent equity returns, and their strong performance has overshadowed small caps. In 2000, a similar situation occurred when large-cap returns were the focus for investors. This shift in investor preferences has contributed to the neglect of small-cap stocks.
At the macro level, small-cap stocks have faced headwinds for the past 2.5 years. Rising interest rates and different debt dynamics compared to larger companies have impacted small-cap valuations. Smaller companies generally sell off first ahead of a potential recession, as their higher debt levels and shorter average debt maturity place them at greater risk in tighter monetary environments. Moreover, smaller companies have fewer sources of financing to rely on, which further adds to their valuation challenges.
Despite these headwinds, there are upside catalysts for small-cap stocks. Smaller companies tend to lead the way ahead of a recovery, and as monetary policy becomes more dovish, small-cap equities should respond strongly. As performance leadership narrows, institutional funds and other investors will start looking for alternatives, and quality small caps are a potential target for capital deployment. Due to their lower liquidity, increased demand for small-cap stocks can lead to significant surges in share prices and a re-rating. Mean regression also suggests that small-cap valuations will eventually return to their long-term average.
Another potential upside for small caps is the M&A market. Currently, willing sellers are hard to find, as many quality companies came to market at high valuations. However, as management teams realize the new reality and the need for continued growth, acquisition may become an attractive option. Historically, small-cap stocks have outperformed their large-cap counterparts over the long term, and there is a small-cap premium. For example, during the period from 2000 to 2005, after the telecom boom and bust, the S&P 600 outperformed the S&P 500 by an average of 12% per year. Currently, the forward P/E of the S&P 600 is at a range similar to that seen during the global financial crisis and the start of the global pandemic. Deploying capital to small caps during those periods was well rewarded, indicating a similar opportunity today.
In conclusion, small-cap stocks are currently undervalued and overlooked, presenting an opportunity for investors. Despite the challenges they face, there are catalysts for upside, including a potential market recovery, M&A activity, and the historical small-cap premium. Investors who are willing to engage in selective stock picking and take advantage of the discounted prices may find opportunities in quality small-cap companies.
