Small But Mighty? Learn More About Small Caps

Ask investors to name a company off the top of their heads, and they’ll likely mention one of the big-name tech or consumer businesses driving the market. When you look at the universe of companies one can purchase, though, there are thousands of smaller businesses that are less well-known than the large operations, but that could still potentially offer decent returns. 

Small-cap companies – businesses with market caps of less than about US$1 billion in the U.S. and below $850 million in Canada – include a wide range of sectors. While few small-caps companies are household names, many of these businesses are established.

Over the last few years, the returns of small-cap stocks have been low relative to large-cap ones – typically defined as companies with a market-cap of more than $10 billion. The Russell 2000, an index that tracks U.S. small caps, has been more or less flat since the start of 2022. Between January and the end of August 2024, the small-cap benchmark was up about 10 per cent, while the broader S&P 500 was up almost twice as much over the same period. It’s a different story in Canada, where the S&P/TSX SmallCap Index has tracked the S&P/TSX Composite more closely during those same months..

If you’re looking to diversify your portfolio or want to find different opportunities outside of the brand name large caps, small caps might be something you could consider. Here are some of the things you should know about this stock category.

Interest rate tailwinds

The U.S. Federal Reserve decision to start cutting rates could change the pace of growth for small caps, says Murphy O’Flaherty, a Senior Portfolio Manager and Senior Equity Analyst with RBC Global Asset Management (U.S.).

Interest rate changes disproportionally affect small cap stocks, she explains, adding the 11 rate hikes over the span of a year and a half created a significant challenge for the category. That’s because many small caps are more dependent on outside financing to fund growth. They also tend to secure less favourable lending terms because, as a group, they can be more susceptible to default than a larger company. This makes them more sensitive to rate fluctuations, which can hinder their earnings growth and cash flow in a rising interest rate environment.

“When you’re a more mature company and you’re profitable and  generating a lot of cash, you probably have multiple options for financing ,” O’Flaherty explains. “Small caps, which are usually less mature and earlier in their development and growth, tend to have less financing flexibility and more exposure to variable rate financing as a consequence.”

Beyond the Fed cutting rates, O’Flaherty notes that small caps are often more focused on the domestic economy than large caps, meaning these businesses are less affected by currency fluctuations and stand to benefit as easing rates take pressure off US consumers, provided there isn’t an economic slowdown that affects consumer spending. 

Growth potential

O’Flaherty says there are signs that institutional investors are starting to shift their focus away from the megacap stocks, which could be a positive sign for small caps. “We’ve started to see earnings growth improve this quarter for select small cap companies, and earnings growth for next year for the Russell 2000 is projected to be even greater than the S&P 500,” she says. In the U.S., the earnings growth estimates for small caps are twice that of earnings growth estimates for large-cap companies¹.

Between the earnings growth expected from small caps and the lower valuations relative to large caps, O’Flaherty argues this could create a more compelling story for the category, which has historically delivered attractive returns.

Investors can get exposure to small caps through exchange-traded funds that track the Russell 2000 in the U.S. or the S&P/TSX SmallCap Index in Canada, or can select individual stocks. Generally, there are fewer analysts covering this space and not as many institutional investors looking at this category, which can create opportunities to find mispriced assets, explains O’Flaherty. Smaller companies may not attract much media coverage, either, but they could still have a strong business model and management team, she notes.

“The opportunity in small caps is to find those mis-priced assets and companies that are sustainably growing key financial metrics like revenue, earnings and cash flow, because this will create shareholder value over time,” she says.

Although the conditions are improving for the category, not all companies will benefit in the same way, cautions O’Flaherty. There are some small-cap companies that are not profitable and may never be, she says. “We went through a decade where financing was easy to come by and you didn’t have to be a very good CEO to run a business, or even be a good business,” she says. “It’s different today.”

Diversification benefits

Small caps can be part of a diversified portfolio strategy. Much of the returns on the larger indices are driven by a handful of the largest companies, particularly those in AI and technology. The top five stocks represent about 25 per cent of the S&P 500 index, meaning if one of those stocks breaks down, it could really impact performance, says O’Flaherty. In contrast, the top five companies on the Russell 2000 only account for a fraction of the index.

It’s also important to know that the small-cap universe includes a wide range of sectors and business models. From a sector perspective, no sector accounts for more than 20 per cent of the overall Russell 2000 index. By comparison, 33 per cent of the S&P 500 is tied up in the tech sector. 

Many of the companies that make up the leading small-cap benchmarks are liquid, meaning they trade frequently enough that investors can get in and out of the investment without significantly impacting the stock price of the company.

Pairing small and large caps in a portfolio can also diversify your holdings between mature and emerging companies. Although small-cap stocks are riskier, part of their appeal is that some have the potential for faster growth, which could catch the attention of large-cap companies. “A lot of Innovation happens in small-cap companies,” says O’Flaherty. “If you’re a larger company, and you identify a company that has shown some real innovation in a sector, then you might decide to buy it rather than build it.”

O’Flaherty says that while she and her team use several tools to identify small-cap investment opportunities, investors can still do some research on their own, pointing to public earnings calls, press releases and financial filings and statements. “There could be quite a lot of value in small cap, but you do have to do the work. Intensive fundamental research and active maintenance needs to be a part of the process,” says O’Flaherty. 

¹ _{Source: Furey Research Partners and FactSet}