We believe small-cap equities are appealing in today’s economic environment. A number of developments have improved their appeal. For example:
- Small caps tend to generate a higher percentage of revenues from the U.S. relative to large-cap stocks. Their domestic orientation generally makes them less susceptible to the strong U.S. dollar, which can adversely affect export demand.
- They have benefited from recently enacted tax reforms. This has tended to make their effective tax rates more competitive with their larger, more multinational counterparts.
- Additionally, small caps have benefited most from other structural reforms in the U.S., including reduced regulatory burdens.
These recent developments complement the attributes of small caps that have made them enticing across different market and macro environments. For example, small caps are generally not as closely followed by sell-side analysts. A relative lack of research coverage creates more opportunities for active managers to identify mispricings and profit from them. Moreover, while not immune to broader market sentiment, small-cap equities are typically less reliant on macro tailwinds and have greater reliance on company-specific drivers.
In the growth space in particular, small-cap equities have their own attractive attributes. These relate to the existence of secular growth opportunities and, for innovative companies, the ability to use the latest technologies to leverage that growth and foster change. We expand on this below.
- Investing in transformation
We believe there are abundant opportunities for small-cap growth investors, especially with respect to companies on the cusp of transformational change. We contend that such companies may have more opportunity to positively influence their own outcomes. By their nature, small-cap growth equities have a propensity to disrupt legacy competitors and cultivate demand for new and innovative business models. These types of stocks provide investors the opportunity to invest in some of the most dynamic companies in the economy that leverage the latest technologies to their advantage.
- Advancements have a positive effect on our daily lives
Many of today’s growth opportunities are in companies that are driving technological innovations. Some of these companies are pioneering advancements in fast-growing areas such as cloud-computing services, software as a service, and the internet of things. While some of these areas may seem opaque, the solutions these companies offer are having a profound impact on the way we conduct our daily lives by reducing costs and increasing efficiency. Some of these important areas include medicine, health care services, security, education, consumer and business services, and infrastructure.
- The cradle of tomorrow’s giants
Several of today’s large companies that are now household names grew from secular drivers that compounded sustainable growth for an extended period. These companies were once constituents of the Russell 2000® Growth Index before graduating to higher market-cap indices. Investors who owned these companies and many like them have enjoyed large returns, as they were able to participate in several multiples of market appreciation.
- Access to growth is limited
Public companies with prolific growth drivers are becoming increasingly important today as competition for growth opportunities from private equity has grown exponentially over the past decade. With the number of listed companies decreasing and access to private equity limited to most investors, the small-cap growth asset class represents an important portfolio allocation for gaining access to these opportunities.
Long-duration equities offer outsized potential
Generally, small-cap growth equities can be considered long-duration equities because their expected cash flows occur further out in the future in comparison with large-cap or value-oriented equities. Small-cap growth stocks are a bet on the future and, therefore, they can be viewed as more risky by investors. This contributes to an often-higher standard deviation of returns relative to other asset classes. Small-cap stocks in general have also historically experienced higher volatility than some other areas within equities.
However, volatility is often accompanied by higher growth and may be rewarded by a higher expected risk premium. Over time, investors can potentially benefit from this risk premium, particularly by maintaining ample diversification to mitigate negative stock-specific events. Because the market is a forward-looking mechanism, we believe it is important to have exposure to a segment of the market where the future can be most positively influenced. Small-cap growth stocks may provide an important and attractive window for investors to gain exposure to tomorrow’s great companies and, as such, we believe investors will continue to have the potential to benefit from allocations to this space.
All investing involves risks, including the possible loss of principal. There can be no assurance that any fund or investment strategy will be successful. Investments fluctuate with changes in market and economic conditions and in different environments due to numerous factors, some of which may be unpredictable. Each asset class has its own risk and return characteristics. Asset allocation and diversification do not ensure or guarantee better performance and cannot eliminate the risk of investment losses.