U.S. small-caps are very cheap by historical standards.  As of November 21, the forward P/E for the S&P 600 Index stood at 12.6, a level well below historical norms for the index. In fact, since the turn of the millennium, we have only seen the S&P 600 dip below 13 twice. Once was in 2008 during the global financial crisis and the other was in 2011 when sovereign debt concerns weighed heavily on stock market valuations across the globe.

In addition to low valuations, small-cap stocks offer an improving earnings outlook, as forward earnings estimates have recently stabilized.

Small-cap earnings have been on a bit of a roller coaster ride in the wake of the COVID-19 pandemic. From January 2020 to May 2020, forward earnings estimates fell by an astonishing 45%. But over the subsequent two years, estimates skyrocketed, cumulatively increasing by 212% as the pandemic shutdown was replaced by a robust reopening of the U.S. economy. However, that period of prosperity was replaced by yet another downturn—one that looked as if it could turn ugly earlier this year.

Fortunately, the U.S. economy has proven more resilient than expected in 2023, which has translated into earnings estimates stabilizing in June and July and subsequently showing signs of upward momentum as we enter 2024.

Unfortunately for small-cap investors, cheap valuations and an improving earnings outlook have recently been overshadowed by concerns about higher interest rates, which pose a notable challenge to many small-cap companies for three primary reasons:

1. Higher leverage. Small-cap companies hold higher debt burdens than large-caps, as illustrated by a comparison of net debt-to-EBITDA ratios. Small-cap net debt is more than 4 times as large as EBITDA, while the large-cap ratio is only 1.42.
2. Thinner margins. While operating margins for small-caps have been gradually increasing over the last 20 years, they stand well below those of large-caps, at 13% versus 21%.  This means that as interest costs increase, small-caps have less of a buffer before profit margins turn negative.
3. Nearer-term maturities. Sixty-four percent of the outstanding debt for small-cap companies matures within the next five years versus only 44% for large-caps. This means that interest costs will increase more quickly for small-caps, as company bonds that were issued when interest rates were at extremely low levels will need to be refinanced at higher rates sooner.

In conclusion, U.S. small-cap stocks offer a compelling combination of attractive valuations and an improving earnings outlook. As a result, our Asset Allocation Committee currently holds an overweight position to U.S. small-cap equities.

However, small-cap companies are likely to prove more sensitive to higher interest rates than large-cap companies. For this reason, we believe it is preferable to invest in this asset class via actively managed portfolios with a higher-quality bias.