There’s been an interesting discrepancy between the stock market performances of U.S.-listed large vs. small-cap companies in 2023. The S&P 500, which comprises the largest 500 companies listed in the U.S., has gained 15% as of June 20th, while the Russell 2500, which includes much smaller companies, has only gained 6% in the same time period.
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So what’s behind that gap? And what can you take away from it?
To dig a bit deeper, it’s interesting to break the S&P 500 into two groups: the Big 7 [made up of Meta (META), Amazon (AMZN), Apple (AAPL), Microsoft (MSFT), Alphabet (GOOGL), Tesla (TSLA) and Nvidia (NVDA)] and the rest (which we call the “laggers”). The Big 7 have gained between 39% and a whopping 189% this year, far outpacing the rest of the index (which has only gained 1% this year). Now, the market is a complex mechanism with stocks that fluctuate wildly on a day-by-day or even minute-by-minute basis. But what’s driving this disparity in performance?
Following the March banking crisis and recent weakness in the U.S. economy, the market anticipates the Fed to pause rate increases — that provides one explanation for the Big 7’s outperformance. Inflation has slowed, but housing remains weak, and many commentators are still expecting a recession by the end of this year. As a result, the market began betting on what has worked well and seemed “safe” over the past decade — otherwise known as large-cap internet stocks. They are well-known, command dominant market positions, and have cash-rich balance sheets.
Moreover, the market has grown ebullient for all things Artificial Intelligence (AI) after ChatGPT reached 100 million monthly active users in January (two months after its launch)... making it the fastest-growing consumer application in history. NVIDIA has been an outsized beneficiary of the AI investing craze because it makes many of the chips powering generative AI model processing. NVIDIA became the 5th company to sport a $1 trillion valuation with a stock that tripled in less than eight months. This AI-driven rally has rewarded market participants deemed to be integrating AI into their product offerings (e.g., Microsoft incorporating ChatGPT into its search engine Bing and Tesla for its potential “AI-powered” robotaxi fleets).
Meanwhile, the regional banking crisis disproportionately hit the small-cap index as a recessionary risk, and the weak asset base of the regional banks became well-known. At the same time, investors became increasingly concerned about small companies’ ability to refinance their debt and meet their liquidity needs during an economic downturn. That’s been compounded because small-caps tend to be in more economically-sensitive sectors like materials, energy, and financials.
These short-term market dynamics look like opportunities to us here at City Different. Because we have a longer time horizon than most market participants (and seek to invest in the fundamentals of a business), we are willing to overlook these short-term market gyrations. Yes, we do agree a portion of small companies will not make it into the next cycle. Still, we’re also finding small-cap companies that have substantial competitive advantages, strong balance sheets, and are generating cash. As such, their survival is not as dependent on market liquidity conditions; and they might even thrive as their weaker competitors die away in a downturn.
Despite their strengths, they are being labeled as “riskier” just because they are small-caps. But that also means some are trading at attractive valuations (single-digit earnings multiples). Moreover, small-caps are generally neglected by sell-side analysts and are therefore under-researched; that allows us to find truly interesting opportunities. That’s why we’re bullish on investing your (and our) assets into these companies.
We’d love to say we’re the only ones seeing these investment opportunities, but according to the Wall Street Journal, “Investors are betting that a turnaround is finally in the works. Investors poured $1.6 billion into exchange-traded funds focused on small-cap stocks last week, according to data compiled by Jefferies. About $3.5 billion has flowed into small-stock ETFs since the start of the year.”
Small-cap indexes are historically more sensitive to broader confidence momentum and tend to perform better if investors feel like the economy is on solid footing. If the economy is seen to be rocky or heading in the wrong direction, small-cap indexes tend to underperform. If the confidence in the economy is indeed on the mend, then small-cap stocks could be poised for a breakout second half of the year.
Remember — most of the big winners today, including NVIDIA, started out as a small-cap not too many years ago.
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