Integrated Equity Quarterly Newsletter

The first quarter of 2024 was marked by continued interest in artificial intelligence (AI)-related stocks, alongside growing signs of an economic soft landing, leading to debate over the number and timing of possible Federal Reserve interest rate cuts. Against this backdrop, we highlight three key themes:

• Momentum¹ experienced historic returns: Momentum had exceptionally strong returns this quarter, representing a top 5% quarter based on quarterly returns dating to January 1, 1990, within the large-cap Russell 1000 Index. Generally, momentum captured high-quality, profitable, and larger-cap stocks with strong growth. Low momentum generally captured the opposite and, in particular, high leverage, as the market penalized firms at risk in a rising rate environment. Digging deeper, common themes within momentum include stocks expected to benefit from the AI capex cycle and adoption, stocks with cryptocurrency exposure in light of the first bitcoin-related exchange-traded funds (ETFs), and higher-quality stocks that have been able to withstand higher‑for-longer costs of capital.
• This was a broad global effect—not just the so-called Magnificent Seven: Alphabet, Amazon.com, Apple, Meta Platforms, Microsoft, Nvidia, and Tesla. It’s convenient to equate the momentum outperformance to outsized winners in AI. However, we emphasize that this is an overly simplistic view, as momentum experienced outsized returns across geographies, styles, and market capitalizations (Figure 1). Larger, profitable companies outperformed everywhere. This reflects the advantages these stocks have had in a higher cost-of-capital economic environment and a preference for quality as various regions and sectors emerge from rolling recessions.
• Our outlook on momentum is nuanced: Many investors have asked for our views on momentum. Having studied this extensively over the years, this is an atypically complicated environment. Historically, the largest momentum corrections have occurred after periods of economic weakness, where deeply discounted (negative momentum) stocks rebounded coming out of a recession (e.g., 2003 and 2009–2010). Smaller momentum corrections have occurred as periods of froth have unwound (e.g., 2000). Notably, the larger momentum corrections were driven by prior losers outperforming, and smaller corrections were driven by prior winners underperforming.

In some ways, momentum looks primed for a correction: It has had outsized recent performance, and we see signs of froth in some areas (e.g., AI and bitcoin) with post-recessionary conditions in others (e.g., real estate and some industrials), and momentum was highly correlated with quality in the first quarter, a common precursor to momentum corrections.

In other ways, momentum does not look traditionally risky. It does not appear overly concentrated in certain sectors or industries; our research shows it is not expensive; many of the high-momentum stocks have very strong fundamentals such that stock performance has been driven by earnings growth rather than by multiple expansion; and markets are at all-time highs, unlike the conditions in which quality and momentum correlations would normally be concerning.

Synthesizing our views, we suggest investors monitor and manage their momentum exposures as appropriate to their situation, analyze whether their momentum is coming from concentrated versus broad drivers, and consider the long and short legs separately (e.g., overweight AI stocks versus underweight cyclical stocks). However, we do not have the evidence or conviction yet to sound a broad alarm on momentum.

Market insight—What we’re monitoring

Given the underperformance of small-cap stocks and lofty valuations among large-caps, investors are increasingly asking about small-cap opportunities at what appear to be attractive relative valuations. It is important to note that when referencing small-cap valuations, much of the commentary refers exclusively to those companies with positive earnings. We think it’s important to analyze the difference between the entire small-cap universe, which includes money‑losing companies, and subsets of the small-cap universe, which could be more attractive.

In this newsletter, we assess the valuation of small-caps using both approaches. We also lay out important compositional changes over the last 20 years in the large- versus small-cap universes, as we think it’s necessary to consider relative fundamentals in any discussion of relative valuation. We share four key findings:

• Small-caps appear to be attractively valued relative to large-caps.
• Compositional changes and weaker fundamentals explain much of the difference in relative valuation at the index level.
• Macroeconomic forces have posed a cyclical headwind for small-caps and are a potential catalyst for reversal.
• We believe that there is a compelling opportunity for active small‑cap investors due to attractive valuations within higher‑quality small-caps, greater dispersion of returns for active stock picking, and the ability to benefit from a potentially improving economic backdrop.

Attractive valuations

For the purposes of this newsletter, we focus on the Russell 2000 Index as a reference class for small-caps and the Russell 1000 Index for large-caps. The performance of small-cap stocks has lagged large‑caps by 666 basis points on an average annual basis over the last five years (as of March 31, 2024), and, more recently, extremely narrow markets have amplified the valuation disparity.

Today, the small-cap stock universe (including companies with negative earnings) is trading at a small premium to the large-cap universe based on 12-month forward price/earnings ratios, but after adjusting for their historical relationship, this represents a 10% discount (Figure 2). We note that this relationship can be noisy due to the inclusion of negative earners, which is why many analysts exclude them. However, we feel it is important to include companies with negative earnings because traditional passive approaches buy the aggregate earnings of all index components and pays for the aggregate market capitalization. From this perspective, the valuation opportunity is mixed.

However, when removing negative earners—to reflect a higher‑quality subset of the small-cap universe—the valuation opportunity becomes much more compelling, with a discount of 25% relative to the historical relationship (Figure 2).

Fundamentals

To understand why relative valuations have changed, we need to understand fundamental changes in the things being valued. We look at relative differences in fundamentals between small- and large-cap stocks over the same period where valuations diverged. A mistake analysts can make when comparing different universes of stocks through time is failing to account for changes in composition between the two things being compared, which can distort results. We highlight three material compositional changes in the small-cap universe compared with large-caps: lower relative profitability, lower relative growth, and changes in relative sector weights.

Change #1: Companies choosing private over public markets limits attractive small-cap stock opportunities

In the past, companies like Microsoft and Intel went public as small‑caps and graduated into the large-cap space. Over time, we have observed that more companies are choosing to stay private until they have a larger market capitalization. This reflects the growth of private equity markets and founders’ desire to forgo the complexities and oversight of public markets. As a result, the universe of public equities has shrunk from over 7,000 in 1996 to over 4,000 today. This means the small-cap universe has lost some of its historically attractive members, and index construction rules imply that passive benchmarks must go deeper into the pool of publicly traded stocks (Figure 3). As a result, the percentage of small-cap companies with negative earnings has risen from about 5% in the mid-1990s to approximately 30% today (Figure 4). Small companies generally have market capitalizations of $10 billion or less, while large companies generally have market capitalizations of $50 billion or more.

The shrinking public equity universe is not the only driver of profitability differences between large- and small-caps. Technology and regulations have increased the economies of scale in many industries, globalization has provided a tailwind to large multinational companies, and large companies have taken advantage of lower interest rates and taxes in the last two decades to boost margins. There has also been a sectoral composition change that we will discuss shortly. All these factors have led to large-caps showing significant improvement in gross margins and profitability that small-caps have been unable to match (Figure 5).

Change #2: The growth advantage of small-caps has deteriorated

As a result of growth companies staying private longer, in tandem with the unprecedented and sustained growth of mega-cap platform companies, the growth of small-caps relative to large-caps has declined. Historically, investors viewed the small-cap universe as a source of superior earnings growth, but our data today suggest that this advantage has dissipated to about parity.

Change #3: Sector composition

With the advantages of scale in technology and platform companies, there has been a migration of information technology stocks from the small- to the large-cap universe. Meanwhile, “old economy” companies with slower growth and greater cyclicality have migrated to the small‑cap space. An illustrative example is the energy sector, where concerns over terminal values have led to declining investor interest—and market capitalization—in these stocks (Figure 6). This compositional mix partially explains relative valuations. Information technology and communication services have gone from a 4% overweight in small‑caps in 2007 to a 22% underweight. This is a huge 26% shift in sector composition from peak to trough over the last 30 years.

We emphasize that, while there are still many quality companies in the small-cap space, these differences in fundamentals are part of the mosaic through which we must interpret relative valuation opportunities.

Macroeconomic influences

In contrast to secular fundamental changes, we also highlight temporary macroeconomic forces that have introduced cyclical headwinds.

Most importantly, rising interest rates have been a double whammy for small-caps. First, small-cap stocks tend to be longer-duration assets, as a greater percentage of their earnings typically lie in the future. As a result, rising rates have had a more significant impact on their justified valuations. Second, small-caps tend to have more floating rate debt, so they are more immediately sensitive to interest rate changes than large-caps. Relatedly, small‑caps have a larger portion of debt maturing in 2024 and 2025, creating a near-term headwind from financing costs. As a result, small-caps have been particularly interest rate sensitive during the recent monetary policy tightening cycle (Figure 7).

In addition, small-caps have underperformed due to concerns about their cyclicality. While many economists predicted a recession that has yet to materialize, beneath the surface we have observed “rolling recessions,” with different industries experiencing growth slowdowns at different times. As small-cap stocks tend to be more cyclical, historically they have struggled more during growth slowdowns but have recovered more strongly afterward.

Looking forward, the market is pricing in some Federal Reserve interest rate cuts this year, as well as a broadening earnings growth recovery. We believe these dynamics will present an eventual tailwind for small-caps when they materialize.

The opportunities in small-caps

Given these offsetting dynamics, our research suggests that there are significant, yet nuanced, opportunities within small-caps. Importantly, these opportunities appear more available to active investors, and we, therefore, have a higher conviction level today in active small-cap management than we do a passive approach mirroring the small-cap index. The three opportunities we will discuss are:

• An attractive macroeconomic setup
• Greater dispersion of returns
• An outsized valuation opportunity in quality small-caps

First, a more attractive macroeconomic backdrop would be a tailwind for small-cap stocks. The market has increasingly adjusted expectations for an economic soft landing (or no landing) alongside measured interest rate cuts, which, historically, has been a positive environment for small-caps. We believe that, if markets are wrong and a recession materializes, falling rates could be a material headwind for small-caps.

Our data, however, support the optimistic view. We have observed a de-synchronized earnings recession in the U.S. by sector and by size. Large-caps started seeing positive earnings growth in the third quarter of 2023, whereas small-caps are projected to see positive growth and acceleration in the second quarter of 2024. Per consensus expectations, the second half of 2024 should see the more cyclical small-cap stocks in the Russell 2000 Index outgrow their large-cap counterparts (Figure 8).

Second, small-cap stocks have greater dispersion (a potentially wide range) in their fundamentals and their total returns. Based on our analysis, the best- and worst‑performing stocks come from the small-cap space. In fact, even in a year dominated by mega-cap technology stocks, a disproportionate share of the highest stock returns in 2023 still came from the small-cap universe (Figure 9). We believe that active management can add significant value in small-cap stock selection, even when the index underperforms, if the skilled active manager is able to exploit this dispersion with outperforming stocks.

Finally, we think there is an extremely compelling valuation opportunity within quality small-caps.

Recalling Figure 2, there is a significant valuation opportunity among the small-caps with positive earnings that is much less compelling for the index as a whole. However, to do the analysis properly, we can’t just look at positive earners because the absolute levels of return on equity (ROE) may still be lower than those in large-caps. To get a true apples-to-apples analysis, we ranked all stocks in the Russell 3000 Index—a proxy for the entire U.S. equity market—by ROE (Figure 10). We note that the small-cap space has a long tail of negative ROE stocks, but both the Russell 1000 and Russell 2000 Indexes have a critical mass of positive earners with similar profitability. To understand the opportunity, we took large- and small-cap stocks with similarly high ROEs and compared their valuations (Figure 11).

The critical takeaway is that among stocks with similarly high ROEs, the small-cap universe is valued at a 34% discount. Why would this be the case? Our hypotheses are:

• The outsized interest in the so-called Magnificent Seven means that many quality businesses are being overlooked, including some of the most attractive stocks in the small-cap space.
• The rise in passive investing, which does not consider fundamental attractiveness, has increased neglect in high‑quality small-cap business models. 
• By lumping all small-caps together, and by favoring large-caps over small-caps, investors may have inhibited price discovery among high-quality small-caps, creating an opportunity for active managers.

Based on our analysis, starting valuations have shown to be highly correlated to long-term outsized returns (Figure 12). Current small-cap valuations provide, in our opinion, a great setup for potential long-term gains. Focusing on the high-quality cohort within small-caps should allow investors to gain from the market dislocation without assuming unwanted risks.

Summary and conclusion

Small-caps appear to be undervalued today relative to large‑caps. We think that the reality is more nuanced and requires a thoughtful analysis of valuation techniques (such as whether to include negative earners) and of the changing composition of small-caps versus large-caps. We conclude that the small-cap index as a whole may be slightly attractive, but it is not a high-conviction view: The index appears to be relatively cheaper than history versus large-caps, but also with weaker fundamentals. The optionality of the asset class is supported by potential macro tailwinds and a compelling starting valuation. However, we believe there is a higher probability and, thus, compelling opportunity for higher‑quality small-caps that have been left behind and are at a historically attractive valuation level compared with history. We believe the supportive macroeconomic backdrop, attractive valuations, and opportunity for outsized returns present a compelling opportunity for active small-cap allocations.

Appendix

Factor definitions:

Factors are our internally constructed metrics defined as follows:

Valuation: Proprietary composite of valuation metrics based on earnings, sales, book value, and dividends. Specific value factor weighting may vary by region and sector. The valuation factor evaluates the relative attractiveness of a company’s stock price as a multiple of company earnings, sales, book value, or dividends paid.

Growth: Proprietary composite of growth metrics based on historical and forward-looking earnings and sales growth. Factor selection and weighting vary by region and industry. The growth factor assesses company growth prospects using historical earnings, sales, and predicted earnings.

Momentum: Proprietary measure of medium-term price momentum. Price momentum measures the change in a company’s stock price, and the momentum factor provides a gauge of market sentiment or persistence of a trend.

Quality: Proprietary measure of quality based on fundamental and stock price stability, balance sheet strength, various measures of profitability, capital usage, and earnings quality. The quality factor assesses the relative attractiveness of a company typically based on volatility, debt servicing capacity, and profitability.

Profitability: Return on equity (ROE) is a financial ratio that measures profitability.

Risk: Proprietary composite capturing stock return stability over multiple time horizons (positive return means risky stocks outperform stable stocks).

Size: The size-based factor helps assess returns based on market capitalization (positive return means larger stocks outperform smaller stocks).

Risks:

Active investing may have higher costs than passive investing and may underperform the broad market or passive peers with similar objectives.

Small-cap stocks have generally been more volatile in price than the large-cap stocks.

All investments are subject to market risk, including the possible loss of principal.