U.S. small-cap stocks have enjoyed a powerful rally since the beginning of July. The Russell 2000 index of smaller stocks was up 10.4 per cent between June 30 and Friday, while the big-cap S&P 500 index was actually down a fraction. The returns year-to-date (up to Friday) still favour big-cap stocks with a gain of 14 per cent versus 11.5 per cent, but the recent reversal has strategists wondering if this is sustainable or a short-term aberration.
The consensus of experts is that small companies tend to have more leveraged balance sheets and are more sensitive to the economic cycle. So, they should continue to outperform as long as interest rates remain in a downward trend and the economy achieves a soft landing.
At first glance, the situation in Canada appears to be even more positive for small-cap stocks. The S&P/TSX SmallCap Index is up almost 12 per cent year-to-date – three percentage points ahead of the broad-based S&P/TSX Composite Index return of just under 9 per cent. Equally important, the differential was more evenly distributed over the entire time frame and not just a dramatic surge during the month of July as was the case in the U.S. market.
With that as background, can we conclude that Canadian investors have expressed a vote of confidence in the small-cap sector and that better days are ahead? As a long-time small-cap value investor, I have to say that these index numbers tell us nothing about investor preferences for small versus large stocks. They simply illustrate the very different economic sector composition of the two indexes.
Most Canadian investors are well aware that banks and financials dominate the S&P/TSX Composite Index with a weighting of 31 per cent as of June 30. They are followed by energy at 18 per cent, industrials at 14 per cent and materials at 12.1 per cent There aren’t many small-cap banks, so you won’t be surprised to learn that the S&P/TSX SmallCap Index has only a 6.5 per cent weighting in this sector. The dominant categories for this index are materials at 32 per cent, energy at 22 per cent and industrial at 12 per cent.
The table shows the sector weighting for the two market indexes as of June 30, and the Composite Index year-to-date return for each sector to Friday.
You can see that the small-cap sector was a major beneficiary of the 32-per-cent weighting in the materials sector (primarily resource stocks) which was up almost 20 per cent year to date in contrast to the Composite index which had a similar weighting in the financials which were up only 8 per cent.
Is 2024 the year to focus on small-cap stocks?
How can we know if investors are being rewarded for a focus on small caps or simply for the different economic sector profile? We can reverse engineer the big-cap Composite Index return to see what it would be if it had the sector weightings of the SmallCap index, but with the original big-cap sector returns. My estimate of this figure is about three percentage points higher, which brings it up to the SmallCap index return. Essentially, all of the apparent enthusiasm for small-cap stocks is in fact an investor preference for economic sectors that just happen to be populated by smaller companies.
You could argue that if investors are moving into economic sectors dominated by smaller companies that this is expressing a preference for small-cap stocks. But when most investors hear about small-cap investing, they think of moving down the market-cap spectrum within the same industry group and not switching to an entirely different economic sector.
As a practical matter, individual investors would be well-advised to ignore portfolio strategist chatter about the optimal economic environment for small- versus large-cap stocks. Smaller companies are more subject to microeconomic events, new product introductions, management turnover and a host of company-specific factors. They are best analyzed on a bottom-up basis with a focus on value.
In that regard, Canadian small-caps do look attractive for the long haul. The S&P/TSX SmallCap Index currently trades at 1.26 times book value, 16 times projected earnings and offers a dividend yield of 2.6 per cent. These are fair valuation statistics for the index as a whole and it is not difficult to find candidates with even more appealing ratios.
Robert Tattersall, CFA, is co-founder of the Saxon family of mutual funds and the retired chief investment officer of Mackenzie Investments.
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