U.S. Small Caps Undeniably Cheap

As earnings season uncovered the creaks at U.S. large cap stocks, investors are now spending more time researching U.S. small cap investment managers. Given a back drop of rising rates and recessionary pressures, it seems like a contrarian view. But the investment managers they are looking at are doing things differently.

2022 Was Not Great for U.S. Small Caps

2022 was the third worst calendar year performance for the Russell 2000. But the same applies to the Russell 1000. Only the aftermath of the bursting of the internet bubble, and the Global Financial Crisis resulted in worse returns, in 2022 and 2008, respectively. But with 2023 coming to an end, and the macro expectations of high but decreasing inflation coupled with a recession, investors are starting to weigh up the potential of small caps in this environment. The attraction to U.S. Small Caps today is supported by valuation. Comparing Small to Large Caps, various multiples suggest the market is trading at lows not seen in almost 50 years. Research inside RFPnetworks also points highlights two interesting characteristics:

1. When inflation is high but falling:

- Small caps outperform during the following 12 month period.

- Small caps outperform large caps during the following 12 month period.

The trick is to capture the start of period that marks the falling inflation. Not easy.

2. Small caps tend to deliver negative returns during the recession, especially for the first three months. But re-rate much faster than large caps, towards the last 3 months of the recession. The end of a recession is often characterised by loosening monetary policy, which benefits small caps more than large caps.

Best U.S. Small Caps For Recessions

Here are 4 examples of the types of U.S. Small Cap companies investment managers like during a recession:

1. Small Cap companies that have managed to keep their balance sheets strong. In doing so, they have protected themselves from rising rates.
2. Small Caps that are not affected by a strong dollar that could hurt non-domestic demand for their goods and services.
3. Small Cap companies that are not affected by supply chain dislocations, or reliant upon maintaining large inventories.
4. And if you can find them, small cap companies which have pricing power with their customers. Which is what the fundamental based research asset managers are doing.

The message from various small cap investment managers is, at very least, keep an eye on this segment of the U.S. market. It can rebound quicker than you realise.