Here we are, almost halfway through 2023, and we’re seeing many of the same investment themes we saw last year. Large-cap stocks continue to outperform, driven by the usual suspects. The Federal Reserve (the Fed) has continued to raise rates at the fastest pace in history. The US debt ceiling still looms. Meanwhile, weak economic data and a tight lending cycle point towards a recession. Given these factors, it may seem like large-cap investments are a safer choice than small caps. But there’s another side to the story.

What’s really driving the so-called large-cap performance? 

Under the surface, a handful of stocks are responsible for driving most of the S&P 500 Index’s outperformance, which also happen to be the same names driving the Nasdaq Composite Index’s performance. The year-to-date return of an equally weighted S&P 500 stands at a mere 0.57%, nowhere near the 7.28% performance for the S&P 500. As for the Nasdaq, Microsoft, Apple and Meta alone account for approximately 30% of the Index, thus driving its results. We believe large-cap indices currently lack adequate diversification to provide safety in a downturn. Their heavy dependence on a single industry, namely tech, is a vulnerability.

As at May 9, 2023

Large caps seem ready to disappoint 

As of March 8, 2023 (the day before the Silicon Valley Bank failure came to light), the Russell 2000 Index was outperforming the S&P 500 by 274 basis points (bps). Understandably, the bank crisis led to significant outflows from small-cap ETFs into large caps, which seemed safer given the circumstances. Consequently, large caps are currently outperforming. However, it’s crucial to bear in mind two key factors. Firstly, the Russell 2000 is still far more diversified (and therefore safer in our view) than the tech-heavy large-cap index. Secondly, we believe patient investors will be rewarded as valuations normalize. 

In fact, we anticipate that small caps will make a powerful comeback as large caps lose momentum, driven by the following reasons.

1. De-globalization leading to lower margins for large caps: According to Goldman Sachs research, S&P 500 margins have risen by 700 bps since 1990, with 70% of the increase attributed to cost savings on goods and the balance to lower taxes and interest rates. However, with de-globalization on the horizon, we believe it’s just a matter of time before investors reduce their overweight positions in large-cap stocks as their margins dwindle. Instead, they’ll turn to smaller caps, which are poised to benefit from local economies. 

2. Historical data shows that periods of high inflation often correlate with stagnant large-cap performance. Take the 1940s and 1970s – two of the worst decades for inflation in the 20th century.

During the post-WWII period, distortions across supply chains and labour markets fueled a 20% spike in US CPI. Large caps went nowhere for the next four years. Similarly, during the stagflation era of the 1970s, large-cap performance remained flat for over five years while quality small-cap stocks emerged as winners.

If we look at recent large-cap performance amidst soaring inflation, we find a similar pattern across three different time periods. As Mark Twain famously said, “History doesn’t repeat itself, but it often rhymes.”

S&P 500 vs. CPI Change Index

3. Remember the Nifty Fifty stocks of the 1960s? These were the esteemed blue-chip companies of that era – expensive but deemed “safe.” The only problem was, when the tide turned, they plummeted to single-digit multiples almost overnight. Today, the five largest stocks account for 20% of the S&P 500, indicating even worse diversity than the dotcom bubble. It begs the question: where else can they go but down?

4. Analyst estimates for the S&P 500 call for earnings to increase from $204 to $225 (+10%) in 2024. Sounds impressive, right? Yet historically, large-cap earnings do not jump that high coming out of recessions (see chart below). In reality, it was the billions of dollars in stimulus during COVID that propelled S&P 500 earnings to grow at an unprecedented pace. Can we really rely on this trend continuing? 

S&P 500 TTM positive operating EPS (log scale) with exponential trend
Grey bars are negative y/y% “industrial production contractions” (R² = 0.9469)

Take advantage of cheap, high-quality small-cap stocks 

For some time now, low-quality stocks have been more expensive than their high-quality counterparts, primarily driven by inexperienced traders. Jefferies reports that lower return on equity (ROE) names are trading at 4.6x sales, a staggering 60% above their long-term average. In contrast, the highest ROE names are trading at 1.2x sales. In our view, this is a clear signal to avoid these low-quality stocks (which are poised to plummet in value) and focus on quality names with strong fundamentals that currently offer attractive buying opportunities. 

So, what exactly makes a quality company? While there may be varying definitions of quality among experts, we can turn to research done by Hsu, Kalesnik and Kose who identified seven metrics used by popular index providers to define quality. These metrics are: profitability, earnings stability, capital structure, growth in profitability, accounting quality, payouts and corporate investment. 

Quality stocks not only exhibit defensive characteristics but are typically less exposed to macroeconomic influences due to lower operational and business risks. Stronger balance sheets and a consistent track record of predictable profits help mitigate downside risk as well.

The secular case for small caps is intact, with a leadership shift to “old economy” stocks, capex beneficiaries and domestic-focused companies from large caps – all of which bode well for small caps. Valuations of small caps versus large caps currently remain near multi-decade lows, suggesting better returns for small caps over the next decade. 

M&A activity is also heating up. While the market overlooks quality small-cap companies, private equity and strategic corporate buyers are capitalizing on the market dislocation to acquire high-quality companies at attractive valuations.

What’s the impact on your portfolio? 

Large-cap and growth stocks have benefitted from the past decade’s zero-rate policy, low inflation and sluggish nominal growth. However, the current macro landscape is ripe for new leadership, which we believe will come from quality small-cap companies. As the chart below shows, large caps seem due to underperform, creating an opportune environment for small-cap leadership. We believe it’s only a matter of time before this transition happens.

Our portfolio consists of market leaders that are outpacing industry growth. These holdings fit the definition of “Quality Small Cap” with strong industry growth, little to no debt and faster earnings growth. Furthermore, they’re trading at a discount compared to their historical valuations.

As the tide turns against large-cap stocks, these companies are poised to benefit. Not to mention, higher interest rates have the potential to benefit our portfolio holdings, enabling them to gain market share and continue to deliver strong and predictable earnings growth.

Large-cap buyers beware; small caps are coming for you.

The UK has historically been a region that attracts significant takeover interest. In this week’s commentary we look at the increase in activity this year, the reasons why and the potential long-term implications for the UK equity market. 

Several factors have contributed to foreign interest in the UK, including its strong presence in the financial and legal sectors, its industrial heritage, a sizeable consumer market and the widespread use of the English language.

Compared to other G7 economies, the UK government has historically been less inclined to intervene on national security grounds when faced with foreign bids for domestic assets. Between 1997 and 2017, despite accounting for only 3% of global GDP, the UK was involved in 25% of global cross-border merger activity. It is estimated that around 50 UK-based firms eligible for the FTSE 100 Index are now under foreign ownership.

For many years, UK equities have been trading at a larger discount compared to their US counterparts. This can be partly attributed to the differing composition of the respective stock markets. The UK has a larger allocation to lower price-to-earnings (PE) valuation sectors, such as energy and materials, which make up around 23% of the FTSE 100 compared to 7% of the S&P 500 Index. Conversely, information technology represents less than 1% of the FSTE 100 but accounts for 26% of the S&P 500. Even considering these factors, the discount had reached approximately 5% leading up to the Brexit referendum in 2016.

Following the momentous decision to leave the European Union, a “Brexit discount” was applied to UK companies to reflect the structural challenges they would face. Furthermore, recent political turmoil, including three prime ministers within a span of fewer than two months towards the end of 2022, has led to an increased risk premium. Consequently, the discount between UK and US stocks has surpassed 40%.

PE discount between UK and US stocks

It is evident that as the discount has grown, the frequency of foreign takeovers of UK companies has also increased significantly. According to the Office of National Statistics, the number of takeovers valued at £1 million or more was consistently between 100 and 300 annually for the 30-year period preceding the Brexit referendum. Since then, the number has exploded. 

This was evident in the first quarter of the year when the deal closed for one of our former UK holdings, Biffa plc (BIFF.LN). Another of our UK holdings, global flexible workspace provider IWG (IWG.LN), has previously attracted takeover interest, while Coats Co. (COA.LN), a global leader in threads, was acquired in the past and later delisted before being relisted a decade later.

A thriving stock exchange can benefit the economy and society as a whole. The capital provided by exchanges enables companies to grow which, in turn, means they employ more people and contribute more taxes for wider public services. However, the number of companies listed in London has almost halved from 2,101 in 2003 to 1,097 today. While this still leaves ample attractive opportunities for investment, the increase in takeovers is just one piece of the puzzle. Another factor has been the decline in new listings. Recognizing the need to adapt and attract more listings, the UK’s financial watchdog, the Financial Conduct Authority, has proposed measures aimed at enhancing the country’s appeal for domestic companies. This follows cases such as UK-based microchip giant Arm, owned by Softbank, opting to list in the US. While streamlining the listing process may remove certain barriers and improve competitiveness, it should not compromise shareholder rights.

The persistently low trading multiples of UK equities leave them susceptible to foreign takeovers. While Global Alpha does not base its investment theses solely on potential takeovers, we acknowledge that it has always been a potential tailwind for the small-cap asset class, and we anticipate heightened takeover activity in 2023. 

In recent years, the U.S. federal government’s debt and deficit have been hot topics in the news. The term “debt ceiling” has once again made headlines after Treasury Secretary Janet Yellen warned that the U.S. government could run out of money by June 1. It’s important to understand what the debt ceiling is, why it needs to be raised and how it can impact financial markets.

What is the debt ceiling?

The debt ceiling is the maximum amount the U.S. Treasury can borrow from the public and governmental accounts. Governments, like individuals, must borrow money when they spend more than they earn and they do so by issuing bonds.

The U.S. has had a debt ceiling for over 100 years, first established in 1917 at $11.5 billion. Prior to this, Congress authorized the government to borrow a fixed sum of money for a specified term. After the loans were repaid, the government could not borrow again without asking Congress for approval.

The debt ceiling was created in 1917 under the Second Liberty Bond Act to make it easier to finance WWI. It allowed for a continual rollover of debt without congressional approval. However, increasing government obligations have led to rising government debts to make up the shortfall between tax revenue and government spending.

What are the issues with raising the limit?

To issue more bonds, the U.S. Treasury must increase the debt ceiling. This has been done without incident for decades, with policymakers raising the limit 89 times since 1959. Most recently, in December 2021, the debt ceiling was raised by $2.5 trillion to $31.4 trillion, projected to fund obligations through mid-2023.

US debt ceiling raises keep pace with the growing national debt (in billions of US$)

Debates surrounding the debt ceiling have become more contentious in recent years. Disagreement has led to two federal government shutdowns in the late 1990s and a 2011 fight that resulted in volatile financial markets and Standard & Poor’s downgrading of the U.S. government’s credit rating for the first time in history. In addition to political reasons, resistance against raising the debt limit has often come from concerns about the sustainability of the massive government debt balance.

The current public debt outstanding is $31.457 trillion, with each U.S. citizen’s share being around $95,000. Economists and government officials often cite the debt-to-GDP ratio, which measures how much of the annual production would be required to pay off the public debt. The U.S. government’s debt-to-GDP ratio of 148% ranks the fourth highest globally, after Japan, Greece and Italy.

What is the likelihood of the U.S. repaying its debt?

In recent decades, the U.S. government has been in deficit almost every year, except for a surplus between 1998 and 2001. It is projected that the government will continue to run deficits until at least 2028, making it unlikely that the government will be able to repay any debt in the foreseeable future. Instead, more debt will likely be added.

US government surplus of deficit, 1993 – 2028 (dollar amounts in billions)

Until recently, the cost of issuing debt to finance federal operations was minimal. However, with rising interest rates, the average interest rate on federal debt has risen to 2.07% in 2022 from 1.6% in 2021. The Congressional Budget Office estimates that interest costs will triple to $1.3 trillion in 2032, becoming the largest federal budget item and surpassing Social Security and Medicare by the middle of the century.

These developments raise concerns that the world’s largest economy may not be able to meet its financial obligations. As a result, the credit default swap (CDS) against a U.S. government default has risen sharply since the beginning of 2023. On May 4, one-year U.S. government CDS reached 152 basis points (bps), up from 10 bps a year earlier and the highest since the 2008 financial crisis. Although the U.S. has never defaulted on its debt, investors are becoming increasingly anxious about the possibility.

What could happen if the U.S. debt ceiling is not raised?

The U.S. government would be unable to borrow money to finance critical obligations, such as Social Security, tax refunds and federal workers and military salaries. This would result in a severe stock market decline and could damage the reputation of the U.S. as a reliable business partner. Interest rates would skyrocket, potentially causing a U.S. or global recession. The dollar may lose its status as the global reserve currency and drop significantly in value.

While the government could resort to temporary financial measures, such as minting a $1 trillion platinum coin, a more sustainable solution is required to address the gap between revenue and spending. This could involve increasing tax rates, reducing expenditures or both.

The debt issue, combined with the tightening credit cycle following the banking crisis, means that borrowing to fuel growth will become increasingly challenging and expensive. Companies with high leverage may face higher interest burdens.

Evaluating financial health to deliver long-term value

We believe investing in companies with strong financial positions, diversified revenue streams, good profitability and no reliance on government subsidies for growth is essential. We take a disciplined approach to investing and carefully evaluate the financial health of the businesses we invest in. Half of the companies in our International Small Cap strategy and a third in our Global Small Cap strategy are in a net cash position. Our portfolios are well positioned to weather economic uncertainties, with a focus on delivering long-term value to our clients.