US small cap: the rebound slowed—but is still rolling on

A positive quarter for small-cap stocks

As long-term small-cap investors, we learned long ago that a quarter is nearly always too short a span by which to judge the worth of investment or the direction of a performance cycle. We were once more reminded of the importance of this observation when reviewing the performance for the small-cap Russell 2000 Index versus its large-cap counterpart, the Russell 1000 Index for 1Q24.

The small-cap index rose a more than respectable 5.2% in 2024’s opening quarter, trailing the Russell 1000, which gained 10.3%. The large-cap index continued to be dominated by mega-cap stocks, as evidenced by the 11.9% advance for the Russell Top 50 Index in 1Q24. Once more, returns skewed higher the further up the capitalization scale one went, with the Russell Microcap Index up 4.7% for the quarter.

Context matters

Yet in our view these quarterly results for the U.S. equity indexes do not tell the whole story. From the most recent small-cap low on 10/27/23, when large-cap indexes were also scuffling, the Russell 2000 advanced 30.7% and the Russell 1000 was up 28.9%. Moreover, from that low through 2023’s high on 12/27/23, the small-cap index rose 26.6% versus 17.2% for the Russell 1000. The Microcap Index was especially strong, rising 30.8% over this 60-day span, while the Russell Top 50 was up “only” 14.8%.

It seems clear to us, then, that the first quarter of 2024 was a consolidation period—a common occurrence after particularly sharp short-term rallies—when investors took gains and/or flew back to the—perceived in our estimation—safety of mega-cap stocks. From 12/28/23 through 3/31/24, the Russell 2000 had a 3.2% gain while the Russell Microcap was up 2.5%, the Russell 1000 rose 10.0%, and the Russell Top 50 was up 11.6%.

Small-cap value and growth vie for long-term leadership

A similar dynamic has played out within small-cap. The Russell 2000 Value Index (+26.8%) and Russell 2000 Growth Index (+26.4%) were virtually neck and neck from 10/27/23 through 12/27/23. This was somewhat surprising, and certainly encouraging, as small-cap value typically trails in short-term upswings, especially those with dramatic, double-digit gains. This role reversal then held sway into the first quarter, as the small-cap value index was up slightly, 2.9%, while small-cap growth rose 7.6%.

This same jockeying for pole position could be seen in longer-term annualized performance periods. The Russell 2000 Value was ahead for the 3-, and 5-year periods ended 3/31/24 while the Russell 2000 Growth led for the 1-, and 10-year periods.

Elsewhere in small-cap

Investing in high-quality small-cap companies—those with high returns on invested capital, discernible competitive advantages, and sustainable business franchises—is a cornerstone of our work. We were therefore interested to see recent results for the S&P SmallCap 600 Index, which, unlike its large-cap S&P 500 sibling, requires that companies meet “investability and financial viability criteria” for index inclusion. For example, prospective constituents must have positive as-reported earnings over the most recent quarter, as well as for the most recent four quarters summed together. This requirement makes the index something of a proxy for small-cap quality.

So, it was interesting to us that the S&P SmallCap 600 trailed off the October low, up 25.7% from 10/27/23 through 12/27/23, and from the December high through the end of March, up 0.9% from 12/27/23 through 3/31/24. These results are potentially important because in our experience profitable companies typically trail during the early stages of sustainable small-cap rebounds.

We also found it notable that small-caps outside the U.S. trailed their bigger cousins—and did so by a wider margin than we have seen over the last several quarters between the two asset classes. The MSCI ACWI ex-USA Small Index was up 2.1% in 1Q24 versus a 5.2% gain for the MSCI ACWI ex-USA Large-Cap Index. Needless to say, this wider-than-has-been usual spread bears watching through the remainder of 2024.

The small-cap sector story

Based on contributions to return, Information Technology and Industrials led the Russell 2000’s 11 equity sectors in 1Q24, followed by Energy. The biggest detractors were Financials—where banks dragged down results for the entire sector—Real Estate, and Utilities.

In spite of their usual sensitivity to falling interest rates, both Energy sector and Health Care were positive contributors in 1Q24. Perhaps most surprising in this context was the impressive strength from the construction & engineering group within Industrials—which was the fourth top-contributing industry in the Russell 2000 for 1Q24.

An optimistic outlook in three charts

We believe that small-cap has important advantages over large-cap that set the asset class up for market leadership going forward. First, the Russell 2000 continues to have a substantially more attractive valuation than its large-cap counterpart at the end March based on our preferred index valuation metric of enterprise value to earnings before interest and taxes, or EV/EBIT.

Small-cap value also continued to sell at a below average valuation vis-à-vis small-cap growth at the end of the first quarter, as measured by EV/EBIT. Those micro-cap stocks with positive EBIT—roughly half the companies in the Russell Microcap Index at the end of March—also remained very attractively valued relative to large-cap based on EV/EBIT. (By comparison, 67% of the companies in the Russell 2000 had positive EBIT and more than 90% in the Russell 1000 had positive EBIT as of 3/31/24.)

Second, we reiterate our contention that as the U.S. economy experiences ever more tangible benefits accrued from reshoring, the CHIPS Act, and several infrastructure projects, advantages will flow to many small-cap companies. Third, earnings growth for small-cap companies is expected to be higher than for larger-cap businesses through the rest of 2024.

Additionally, we tend to hold companies with little or no debt—a distinct advantage in our view in a world where the cost of capital matters again.

Finally, we understand the frustrations of investors who have experienced underwhelming small-cap returns, especially for the 3 years ended 3/31/24, when the Russell 2000 lost 0.1%. However, when the small-cap index had low or negative returns over annualized 3-year periods, subsequent 3-year annualized returns were positive 99% of the time, in 66 of 67 periods, and averaged an impressive 16.7%, beating the Russell 2000’s long-term average annualized 3-year return of 10.7%.

With valuations, earnings, and fundamentals all favoring select small-caps, we are decidedly optimistic about the prospects for active and risk-conscious small-cap management going forward.