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Goldman Sachs Asset Management Statement on the Russia-Ukraine War. Read it here .


March 14, 2022 | GSAM Connect

David vs Goliath: Don't Underestimate the Small (Caps)

Ever since Eugene Fama and Kenneth French included the small-versus-big factor1 in the Fama/French stock pricing model three decades ago, it’s become a truism of sorts for investors: smaller companies do better than larger ones over the long run. And to be sure, the data bears it out. Since 1927, US small caps have outperformed large caps by roughly two percentage points (pp) on an annualized basis2. But while the trend persisted during the 12 months following the March 2020 market selloff, it has since reversed, prompting some to wonder whether the macro environment remains supportive for US small-cap stocks. We believe it does, though the asset class will likely face some near-term challenges.


Growth Matters. Inflation Does, Too

We’ll start with economic growth. It has been a big driver of small cap performance over time. Consider how small caps rebounded in tandem with the economic recovery that followed the market downturn in March 2020. Growth is not the only macro factor driving the performance of the asset class, though. Inflation plays a vital role, too. Compared to large cap companies, small caps have tended to be price-takers, meaning they don’t always influence the price at which they sell a product or service or easily negotiate what they pay for their inputs. In periods when inflation is high and rising companies that struggle to pass on the price increase to consumers can get penalized, which can hurt their profitability.

This helps explain why US small caps have lost some momentum recently despite consistently strong economic growth. Exhibit 1 plots the relative performance of US small-cap vs large-cap stocks against US CPI inflation since March 31, 2020. It illustrates that the acceleration of US inflation since Q1 2021 has been associated with an underperformance of small caps relative to large caps. This shift in direction would likely persist should inflation continue to edge higher.


Source: Bloomberg and Goldman Sachs Asset Management. Last data point is February 2022. As of March 10, 2022. “US Small vs Large” refers to MSCI US Small Cap Index vs MSCI US Large Cap Index. US CPI Inflation is year-over-year inflation rate. For illustrative purposes only. Past performance does not guarantee future results, which may vary.


Normalizing Inflation Should Revive the Rally

In the US, inflationary pressures have become more broad-based with core inflation hitting 6.4% in February. Cyclical components such as shelter costs and wages have started to rise more rapidly, but a big part of the overshoot is still driven by goods inflation as global supply chains remain disrupted. While Russia’s invasion of Ukraine creates additional uncertainty around the pace of inflation normalization, we continue to expect headline inflation to peak in the coming months. In our view, moving down in market cap may benefit portfolio returns as the Federal Reserve begins to tighten monetary policy and inflation eventually normalizes. History suggests that such an environment may be favorable for small caps. Exhibit 2 shows that small caps outperformed their larger peers by 5.1 percentage points when inflation declined from a high level and the Fed cut or kept the federal funds rate unchanged. The outperformance was even more pronounced when the Fed tightened: US small caps delivered an excess return of 6.7 percentage points on average.


Source: Kenneth R. French, Federal Reserve Bank of St. Louis, and Goldman Sachs Asset Management. “US Small vs Large” refers to Fama & French’s SMB factor. The time period is July 1954 to December 2021. As of February 21, 2022. Annualized average of monthly total returns. US CPI Inflation is year-over-year inflation rate. For illustrative purposes only. Past performance does not guarantee future results, which may vary.


Is a Rising Real Yield a Real Threat?

Rising real yields in the US may pose a challenge for small caps. A growing number of small-sized US companies have zero or negative earnings, which may raise concerns about their ability to sustain higher debt servicing costs. For investors, that means selectivity is important. Even so, real yields, while rising, remain in negative territory and fundamentals at the aggregate level remain solid3. Over the next 12 months, consensus estimates point to healthy balance sheets4 and record earnings5. Total net debt by year end is estimated to be about one-fifth of that in 2018, which should offset the fact that small-cap companies have a higher share of floating rate debt than their large counterparts. In our view, small caps are likely to deal well with higher real yields.


Valuations are Cheap Relative to History

Exhibit 3 shows that relative valuations (small vs large caps) are low globally making the asset class attractive. In the US, the 12-month forward price-to-earnings ratio (fwd PE) for small caps was 18.8 at the end of February 2022, compared to 20.4 for large caps - a discount of about 8%. While small caps do not trade at a discount everywhere, they are near the low end of the historical range across regions.

Exhibit 3: Small vs Large 12m Forward PE Premium (or Discount) Since 2010 (%)

Source: Bloomberg, and Goldman Sachs Asset Management. Time period is January 2010 to February 2022. Last data point is February 2022. As of March 3, 2022. Each country/region refers to its corresponding MSCI index. For illustrative purposes only. Past performance does not guarantee future results, which may vary.


Deteriorating Growth is the Main Risk

In our view, the main risk to small caps is a significant slowdown in economic growth. To this end, we’re paying close attention to the Fed, which is set to hike rates this month and provide new guidance about the pace and the magnitude of its monetary policy normalization. A policy mistake leading to slower growth, or a recession in the worst-case scenario, would not only affect smaller companies but lead to a broader flight to safety. For now, though, we only assign a 20% probability to a recession in the US in the next 12 months. What’s more, we think that, as the impact of Omicron fades, the US economy will start to accelerate again in the second quarter thanks to further service sector reopening and spending from excess savings. While the recent Russian invasion of Ukraine may affect international trade, we expect the direct impact on global growth to be small. Also, the effect on the US economy specifically should be limited as trade links are weak and the country is less sensitive to energy prices than Europe.


Time for Small Again

Overall, the macro outlook for US small caps is likely to stay supportive as growth remains robust and inflation eventually moderates. In addition to a favorable macro backdrop, historically low valuations and overall healthy fundamentals may offer great opportunities for selective investors in the coming months.


1This size effect suggests smaller market-capitalization companies should offer strong returns to the market over the long run.

2Performance calculated using Fama & French’s SMB factor.

3 The aggregate level refers to the MSCI US Small Cap Index.

4 The net-debt-to-EBITDA ratio is expected to be about 0.4 (compared to 3.7 before the pandemic). As of February 2022.

5 EPS are expected to reach their highest level in 10 years. As of February 2022.

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