Small caps could be big in 2025

The rise of Nvidia, along with the rest of the Magnificent 7, has captivated the market over the last few years. However, these kinds of companies are not where investors have traditionally seen the biggest growth. Historically, this has been the purview of small caps.

The “size effect” explains the phenomenon of small stocks outperforming large stocks over longer periods of time, and it was first documented in Rolf Banz’s dissertation on the pricing of US small companies in 1981.

Even before Banz put a name to it, the size effect was a concept American investing pioneer Peter Lynch was already familiar with. Widely regarded as one of the most successful fund managers of all time, Peter understood that small caps often represented the intersection of entrepreneurship, innovation, and potential outsized returns. After he took over the Magellan fund in 1977, he successfully picked several early-stage companies.

The size differential between small caps and large caps is considerable. Companies on the S&P 500, which comprises the 500 largest listed companies in the US, have a minimum market cap of US$18 billion. On the other side of the market capitalisation pendulum is the Russell 2000, the commonly used benchmark for US small caps, where the minimum threshold market cap for new additions is US$150.4 million.

The Russell indices were first established in 1984, during a time when small cap companies were seen as the Wild West: a large and mostly unsettled landscape where the usual conventions of investing did not necessarily apply. This perspective hadn’t much changed when Nvidia joined the Russell 2000 in 1999, then worth US$626 million based on its initial public offering. Now, at the top of the S&P 500, Nvidia is worth US$3.35 trillion.

Nvidia’s story reflects the immense potential of small-cap investing – the prospect of hooking a big fish while it’s still a minnow.

More recently, as we know, the size effect has not been observed. One of the main reasons has been the higher rates environment. Smaller companies are more dependent on external funding to help grow the business, and during the global tightening cycle, bank debt had became too expensive, and the higher cost of capital saw other funding sources such as merger & acquisition activity and venture capital investment dry up. Importantly, small companies tend to be domestically focussed and are leveraged to the households and corporates purchasing their goods and services. Rapid rate rises, as we recently experienced, had a disproportionately larger impact on small companies' returns.

Small caps have historically underperformed large caps leading into an economic contraction, and we have seen this play out with the performance of the S&P 500 since 2019. In the next phase, this dynamic generally flips when the economy enters recovery. The Federal Reserve announcing a rate cut in September was seen as beneficial for small companies, and the market responded by boosting the Russell 2000 by 2.1%.

Less than two months later, the Russell 2000 got a second boost with Trump’s election win. The President-elect’s campaign rhetoric included tax relief for corporates and lighter regulation, which has been seen to benefit small caps more than larger companies. The markets gave this development a warm reception, with the Russell 2000 gaining by 7.8%.

At the time of writing this column, the Russell 2000 had gained yet again off the back of Scott Bessent’s appointment as Trump’s new Treasury Secretary. Bessent’s hedge fund background seems to have allayed some of the concerns over Trump’s economic agenda, and the stock markets expressed approval of the appointment with another rally, pushing the Russell 2000 up by 1.5% to a new all-time high.

It has been a promising start to the small caps rebound, however it should be noted that the most recent gains have largely been built on the anticipation of more favourable conditions in the future. Things can change. Inflation could return. The Fed could hold rates, or worse, revert to a tightening cycle if the cost of goods and services spikes.

Jim Simons, a renowned quantitative investor and founder of Renaissance Technologies, emphasised the need for rigorous due diligence when investing in small-cap stocks. The potential for high returns, he said, is balanced by the risks, therefore investing in small caps successfully often requires detailed analysis and careful evaluation.

Australian investors have not traditionally invested in US small caps. Our dealings at this end of the market have largely been limited to the S&P/ASX Small Ordinaries (Small Ords), and it would be fair to say that the experience may not have left a good impression. Since the S&P/ASX 200 index series first launched in 2000, the Small Ords have underperformed the large-cap dominated S&P/ASX 200 by a wide margin.

However, the Australian market is very different to the US market. Here, the average market cap for small caps is A$1.7 billion. The small cap universe in the US is a lot bigger. If we look at the Russell 2000, the small caps included in the index have more than double the average market cap at A$5.4 billion. The Small Ords is also replete with companies in their infancy or startup phase, which is an even riskier part of the business cycle, and there is a percentage of explorers and unprofitable resource companies.

As always, it pays to be selective. Reviewing fundamentals remains critical, especially in the small-cap universe, because the reality is that many of these companies are not making money and would not be considered attractive from an investment perspective. The bet would largely be on management and the business model.

A widely regarded investment approach is identifying companies based on their quality fundamentals. Inspired by investment pioneers Benjamin Graham and Warren Buffett, the quality factor focuses on return on equity and balance sheet strength, and these attributes could potentially help investors navigate the small-cap landscape over the next cycle to find the next big growth opportunities.

Quality small companies could become the next big thing, and well-diversified investors should have an allocation to the potential of small caps outside Australia. To quote a Lynch-ism, “Big companies have small moves, small companies have big moves”.

This article was originally published in The Australian on 30 November 2024 as “The whales were minnows once: It’s a golden moment for small cap stocks”.