Small caps – Europe ahead, US behind for a change

Over
the last five years, indices of US small-capitalisation stocks sharply
underperformed large caps, while in Europe, the opposite was the case. The
prime reason for the divergence has been the dominance of large-cap technology
stocks in the US which have had a bumper run. Should we expect a reversal in
the fortunes of small caps?

Extended periods in which small caps
underperform large caps are not unusual. The US Russell 2000 small-cap index
lagged the broad market S&P 500 by 8% (annualised) between 1983 and 1990
and by 11% per year from 1994 to 1999.

Explanations for the 1980s lag include
the increased use of index arbitrage by institutional investors, the rise of
globalised investing, mergers and acquisitions, and a weakening US dollar. In
the late 1990s, a key driver was the inflation of the technology, media and
telecom (TMT) bubble. This gives us a clue as to the reason for the divergence
over the last five years.

Tech holds the key

Historically, the relative performance of the EuroSTOXX indices has been similar to that of the US indices. However, since mid-2015, European small caps have continued to outperform large caps, while US small caps have lagged (see Exhibit 1). The technology sector accounts for most of the discrepancy.

In contrast to the TMT bubble of the late
1990s, when European shares actually rose by more than those in US, Europe has
not participated in the latest tech sector surge.

The broad tech sector (including internet
retail and media & entertainment) makes up 38% of the MSCI US IMI index
(which incorporates small-cap stocks), but just 10% of the European index.

Comparing the contribution by sector of
small-cap outperformance and underperformance illustrates how tech has dragged
on US small-cap returns.

Since June 2015, European small caps have
outperformed large caps by 2.5% annualised, while US small caps have lagged
large caps by 5.7%. The biggest contributors to this divergence were technology,
financials, and consumer discretionary ex-internet retail (see Exhibit 2).

Notably for small-cap financials and real
estate, Europe outperformed, but the US underperformed. This shows that there
were other reasons than just tech for the US small-cap underperformance. Even
excluding tech still does not result in superior performance relative to large
caps (see Exhibit 3).

What about the future?

Given the relatively poor performance of US
small caps over the years, it should not be surprising that valuations are now
in small caps’ favour, but again, it is crucial to account for the tech sector.

Historically, small caps trade at a
premium to large caps: about 25% higher in the US and 10% higher in Europe.
Currently, the premium in the US is just 8%, suggesting small caps are cheap.

But when we exclude the expensive tech
large caps, the premium rises to 30%, matching the long-run average. Europe
multiples are similar, so there is no obvious opportunity simply based on
valuations.

Earnings
views brighter for US small caps

Analyst earnings revisions have been much
more positive for US small caps, but this mostly reflects an expected rebound
after the even bigger collapse in expectations at the onset of the pandemic.
Estimates are still 27% below February levels, while US technology estimates
are just 3% lower.

As for large-cap tech, it is notable that
since May, second-twelve-month forward earnings estimates have risen by less than they have for the rest of the
market. The significant gains in tech share prices since March assumedly
reflect a big rise in future earnings, but analysts do not seem to share that
view.

The lack of more positive earnings
estimate revisions explains why multiples for the sector have risen so sharply
this year, and remain high even after the correction over the last few weeks
(see Exhibit 4).

What
will it take small caps to gain the lead?

For US small-cap indices to outperform large caps, we will need to see a more
significant, sustained correction in tech valuations. Small-cap stocks outside
of the tech sector can certainly outperform, as Europe has shown, though with
valuations at average levels, the potential is modest.

A recovery from the recession,
particularly in consumer sectors that were hit badly by the lockdown
restrictions, should result in a stronger bounce.

A Democratic sweep in November’s US
elections would be particularly helpful as the expected fiscal stimulus would
focus on domestic spending and income support, while any tax increases will
affect companies. Offsetting this is the US weaker dollar. This typically
benefits large-cap stocks.

Also
read:

• US
  small caps set for ‘several years of dominance’ and other articles by Pamela Woo,
  head of US equities

Any
views expressed here are those of the author as of the date of publication, are
based on available information, and are subject to change without notice.
Individual portfolio management teams may hold different views and may take
different investment decisions for different clients. This document does not
constitute investment advice.

The
value of investments and the income they generate may go down as well as up and
it is possible that investors will not recover their initial outlay. Past
performance is no guarantee for future returns.

Investing
in emerging markets, or specialised or restricted sectors is likely to be
subject to a higher-than-average volatility due to a high degree of
concentration, greater uncertainty because less information is available, there
is less liquidity or due to greater sensitivity to changes in market conditions
(social, political and economic conditions).

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Writen by Daniel Morris. The post Small caps – Europe ahead, US behind for a change appeared first on Investors’ Corner – The official blog of BNP Paribas Asset Management.