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Markets

Pricing Higher Risks and a Potential Economic Slowdown

Sizing the Opportunity: Small/Mid-Cap Stocks Offer Positive Exposure to a U.S. Economic Surprise

Higher risk within small/mid capitalization markets can create opportunity, especially for bottom-up, fundamental analysts. The primary reason is rising volatility, mixed with stronger correlations between stock returns within the asset class, creates dislocations from fundamentals for some stocks. While finding these dislocations is difficult within an uncertain environment, it is during uncertain times when quality companies that are structurally important to the long-term growth of the economy can be found for relatively cheaper prices. The momentum of a trend can persist longer than people think is reasonable or warranted, as we saw in 2020, yet efficiency and rational thought tends to prevail over the long term.

Within U.S. markets, the small to middle capitalization range tends to be more sensitive to macroeconomic conditions within the United States than larger capitalization stocks. There are several reasons for this phenomenon, including more relative revenue exposure to the U.S. economy, tighter balance sheets, and less ability to pass higher costs to consumers than larger peers. Thus, as economic conditions within the U.S. deteriorate, inflation persists longer than anticipated and larger risks to economic growth materialize, U.S. small/mid cap stocks tend to struggle relative to their larger peers.

As shown in Figure 1, small/mid cap stocks have recently traded at a premium to their larger cap peers due in part to higher growth expectations over the long term and higher than market-cap weighted allocation by some investors. However, this premium transformed into a discount starting this year as economic expectations deteriorated amid higher interest rates and a surprise negative GDP reading during the first quarter of 2022.

Figure 1: FY1 P/E Ratio

However, an interesting dynamic has emerged this year when growth expectations for stocks are considered against the macroeconomic backdrop.  As Figure 2 shows, small/mid cap stocks are also relatively cheaper when looking at the PEG ratio (which takes the price to earnings ratio and divides it by future growth expectations on a one-year forward basis). In other words, small/mid cap stocks are now cheaper than large cap stocks, even when relativizing the measure based on future growth expectations.

Figure 2: Russell 2500/Russell 1000 FY1 PEG Ratio

Given that smaller market cap stocks are more sensitive to the U.S. economic environment, this makes sense if the market is working out the probability and severity of a potential economic slowdown or even recession brought upon by higher interest rates, inflation, supply chain bottlenecks, and other dislocations arising as the world shifts towards the post-lockdown pandemic environment. The risk may not yet be reflected in the fundamentals of the business because it remains unknown. As shown in Figure 3, the relative returns of small/mid cap stocks versus larger cap stocks tend to lag during market downturns but rebound relatively quickly.

Figure 3: Rolling 1-Year Relative Performance: Russell 2500 vs. Russell 1000

In this environment, our focus within the asset class remains on companies that are fundamentally resilient, have higher quality business characteristics and balance sheets, and exhibit some degree of stability. A long-term focus is important within the small/mid cap market as is an acknowledgement of short-term realities such as volatility. We also search for dislocations within the higher growth segment as it has sold off more than other areas of the market. Despite the uncertainty, and in some ways due to the current environment, the setup for small/mid cap companies is more interesting this year than it has been in the recent past if the U.S. economy surprises with robust growth and stocks become more dislocated from fundamentals.

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