Do small caps or large caps perform better in recessions?

A number of recession indicators are either flashing red or on the cusp of doing so. And, as bottom-up stockpickers, we don’t need to look far to find evidence that these are challenging times for companies.

Investors may ask themselves if now is the time to skew equity allocations to more liquid large caps. From an emotional perspective this feels like a logical investment strategy. The data on investment returns, however, suggests quite the opposite.

Investing in small caps during recessions has generated superior investment returns, according to our back-testing of the data to the late 1980s (see Table 1, below). This near 40-year period encompasses numerous recessions, across the US, Europe and Asia which have followed a whole array of regional crises, and includes the rare synchronised global downturn of 2007/08, following the Global Financial Crisis.

It’s hard to accurately identify the turning points when economies transition between the four stages of the economic cycle: slowdown, recession, recovery and expansion. History provides a long list of averted recessions, including 1995/96 when the US managed a soft landing after an interest rate tightening cycle, or this winter in Europe where the reality has been considerably more moderate than feared.

That said, the Schroders Global Wave (SGW) model has a pretty good track record of flagging US recessions, as illustrated by the overlap between US recession periods defined by the National Bureau of Economic Research (NBER) (see chart 1, below). The NBER has the role as the official recorder of the US economic cycle.

The SGW was also timely in picking up recession in Asia in 1998 following the Asian Financial Crisis, and recession in Europe following the Eurozone Sovereign Debt Crisis of 2011/12. At the present time it’s not far off the point when it flips from slowdown to recession (see graphic, below) which aligns with the picture we see from macro and micro indications around us.

Combining this real-time intelligence with our research findings suggests, at the very least, sticking with small caps at the present time. Certainly, small cap valuations are at a level of relative cheapness versus global large caps which is historically rare and have historically provided for periods of medium term outperformance.

Recession fears to date have disproportionately hit the valuation of small companies. This can be rationalised because they are more economically sensitive and less liquid than large caps, a characteristic which explains why we have to be macro aware. To some extent, the broadly higher quality of large cap companies allows them more control of their destinies, given their size provides for greater diversification of revenues and operating risk, and greater supply chain power.

On top of this, in times of greater future uncertainty investors seek more security. This causes capital to be re-deployed to areas with greater liquidity, given that the priority of short-term safety can outweigh the pursuit of long-term returns.

With this knowledge, the market tends to sell small companies heading into a recession in favour of more liquid large cap stocks. The selling, however, gets overdone. We’ve all seen footage of a herd of animals turning on a dime to avoid danger, and it’s a similar picture with the rush of capital away from small caps heading into recession.

Rush of capital away… and then back into small caps

Once we’re in recession, however, and as the market begins to discount recovery, there is an equally forceful rush of capital back into small caps. Investors are now anticipating benefiting from the sensitivity of small cap earnings to the recovery.

At the same time, valuation re-ratings can be very powerful as the spiral of liquidity concern during the dash for safety impairs the valuations of small caps to well below what is fair from a purely fundamental perspective.

The data tells us this combination of recovering earnings expectations given a more supporting economic backdrop and valuation re-rating from renewed confidence continues well into the recovery phase of the economic cycle. As a result, from an investment perspective recession and recovery (R&R) should be looked at as one state, rather than two discrete phases.

This data insight also certainly makes intuitive sense to us. As an economic recovery gathers momentum we see a pattern of successive upward earnings revisions, so higher multiples are applied to higher earnings, and so on.

Additionally, the creative destruction during recession is often more consequential for small companies under more pressing need to right-size their cost base. As a result they enjoy commensurately more efficient earnings generation during the recovery given how lean and efficient they have become.

Our findings are broad based and chime with broad body of research

Small caps strongly outperformed through the R&R phase across every region we tested. And our findings chime with the broad body of academic research which finds small high quality companies significantly outperform their large cap equivalents over all variety of economic conditions and time periods.

When quality is controlled, small caps are found to have outperformed during some surprising periods, including in the long run up to the Technology, Media and Telecoms (TMT) boom of the late 1990s when, on the face of it, large caps had been the place to be.

This, in combination with the knowledge of the world economy spending something approaching half the time (40%) in the R&R phase (see long stretches of blue in Chart 2, above, versus green for the expansion and slowdown (E&S) phase), speaks loudly to us in favour of an evergreen small cap allocation.

The tendency for small caps to price in a much worse outcome going into a recession could also be seen as a tactical opportunity at the present time.