A tale of two countries and one style: US and UK small caps
A tale of two countries and one style: US and UK small caps
The Covid-19 pandemic has had a devastating impact on businesses around the world. Small companies have been particularly hit by the lockdowns given that they are generally more highly geared with less cash in reserve going into the crisis. A recent report by the New York Fed highlighted that merely 35% of US small companies were healthy at the end of 2019 and “only one in five healthy firms had sufficient cash reserves to continue normal operations if they experienced a two-month revenue loss”.
Diverging performance fortunes of US and UK small caps
Against this challenging backdrop for small companies, the UK FTSE small cap index has managed to recover from the March lows to near record highs against its larger peer, the FTSE 100 (chart 1). By stark contrast, US small caps have failed to keep up such that the performance of the Russell 2000 small cap index relative to the large cap S&P 500 is still below levels seen prior to the March sell-off.
The lacklustre fortunes of the Russell 2000 this year is explained by the sector and style tilts of this index. Table 1 shows that the US small caps index has lower exposure to growth sectors such as information technology (tech), but is overweight industrials and financials. On performance year-to-date (YTD), relative to the S&P 500, the Russell 2000 is down 10% driven by the disappointing return from small cap financials and the stellar performance of large cap tech (table 2). In this recessionary environment, investors have hugged the growth areas of the market, which are in a better position to weather the Covid storm (see here).
In comparison, UK small caps are heavily dependent on financials doing well as this sector dominates the FTSE small cap index by around 47% more than the broader market. But while banks account for nearly half of the market capitalisation of financials listed on the FTSE 100, they make up barely 1% of the small cap index, which is instead dominated by investment trusts. With small cap financials rallying to the tune of 29% on a relative basis, the small cap index has beaten the FTSE 100 by 5.3% YTD. At the same time, the drop in energy and consumer stocks has been the performance drag on the large cap index.
Meanwhile, some of the investment trusts in the UK small cap universe have benefitted from having high exposure to the growth sectors, which have outshone their value counterparts. If we exclude the gains from investment trusts, then small companies have lost 3.4% YTD against larger corporates.
How do small versus large cap valuations compare?
Over recent months, the 12-month trailing price-to-earnings ratios (P/Es) for both US and UK small caps have surged, which has resulted in multiples being roughly two times higher than P/Es for large caps (table 3). However, the Russell 2000 P/E ratio has been distorted by the slump in earnings due to Covid. If we excluded the negative earnings from the trailing P/E ratio, then US small companies would be trading at a lower multiple of 17.8. Meanwhile, the dividend yields for small and large caps are trading at similar levels with the price-to-book ratio lower for small caps.
Simply ranking these valuation metrics by their z-scores (a way to standardise indicators) based over the last 10 years results in US small cap valuations looking less attractive than their UK neighbour (cells highlighted in blue is more favourable to red less favourable in table 4). Although US small caps are looking richer from a price-to-earnings perspective, the Russell 2000 appears more compelling based on the dividend yield and price-to-book ratio.
The currency matters more for UK small caps
Despite the Russell 2000 being less international in nature than the S&P 500, there appears to be no strong relationship between the US dollar index and the outperformance of small caps. Instead, there is a positive correlation between the UK small cap premium (i.e. the performance of small caps versus large caps) and trade-weighted sterling (chart 2). With the FTSE 100 deriving at least 70% of revenue overseas, compared to less than 30% among the S&P 500 companies, the impact from a weaker sterling matters more for the performance of UK small caps versus large caps (see here).
Are small caps poised to benefit from the lower interest rate environment?
From an economic cycle perspective, US small caps have typically surpassed their larger peers in the performance stakes towards the end of the recession phase (see here). This is because investors have sought smaller companies, which are anticipated to benefit from the recovery in corporate profitability. In particular, US small caps are more sensitive to lower interest rates and tightening in credit spreads as they tend to be more leveraged than their larger counterparts.
Chart 3 shows that the performance of US small caps relative to large caps (small cap premium) is generally positive when interest rates are falling over the month and negative when the Federal Reserve (Fed) is hiking rates. Since the Fed started cutting rates in the summer of 2019, the Russell 2000 has being underperforming the S&P 500. This suggests that the US small cap premium has suffered from the strong tech rally, as investors have stayed away from this style despite the more benign interest rate environment.
In the UK, small caps appear to be less impacted by the interest rate landscape. Instead, the performance of the small cap premium has been generally stronger when the central bank is tightening monetary policy. This is likely due to the FTSE small caps compared to the FTSE 100 having a 17% underweight in the consumer sectors, which are sensitive to higher interest rates.
What’s next for small caps?
While UK small cap valuations remain supportive for this segment of the market, there is arguably more scope for a performance catch up of US small caps relative to large caps. The unprecedented amount of policy support from the Fed and government aid to small businesses should be helpful for the recovery of profitability among small companies. However, investors will need confirmation in the data that the Covid situation is improving and the US economy is on a stronger growth path before letting go of the growth parts of the equity universe.
 Source: Can small firms weather the economic effects of Covid-19? New York Fed, April 2020. https://www.fedsmallbusiness.org/medialibrary/FedSmallBusiness/files/2020/covid-brief
 Source: FTSE Russell, 31 July 2020