Small caps on the sidelines, but for how long still?

Small caps have been overshadowed by large and mega-caps for the last two-and-a-half years, but their underperformance phase may now be nearing its end. In Europe in particular, the risk-reward tradeoff is good for those investors with a medium-term perspective. However, active management is necessary in order to be able to profit from the dynamism of the hidden champions. Meanwhile, many star performers are staying away from stock exchanges these days, but investors nowadays can nonetheless participate in the performance of those privately held growth companies.


Overshadowed by the big boys

Small caps have been living in the shadows on equity markets for quite some time. The investment case for this equity category, which is based in part on the small-cap premium that can be captured over the long term and on the greater alpha opportunities that “little” stocks offer, has not persuaded investors over the last two-and-a-half years. They have preferred instead to stick their capital in the Magnificent Seven in the USA or in the European GRANOLAS. By contrast, it takes a proverbial magnifying glass to search for a good performance among the purported hidden champions in the equity universe. Strictly speaking, the weakness of small caps versus large caps since November 2021 (which marked the cyclical peak in small-cap indices) constitutes one of the widest performance discrepancies in history – the underperformance of small caps during this period exceeds 20 percentage points in the USA and even amounts to around 30 percentage points in Europe.


Lagging behind | Persistent performance gap between small and large

Performance of small- and large-cap indices

Sources: Bloomberg, Kaiser Partner Privatbank


The weak performance, though, is only partially explained by AI fever and the motto “big is beautiful.” It also has fundamental causes. For instance, the more cyclical small caps have been affected more than large caps by the dip in economic activity in recent quarters (particularly in Europe), by the rise in interest rates, and by the intermittent overshooting of inflation. So, on the bottom line, they have also posted notably lower earnings growth. However, this reality has been more than priced in by now because the valuations of small caps have contracted by more than 30% since the start of 2022.


Big is beautiful… | …especially among US growth stocks

Small vs. large on the US equity market

Sources: Bloomberg, Kaiser Partner Privatbank


Cyclical investment opportunity

In fact, viewed objectively, small caps have to be considered a real (relative) bargain today. In terms of price-to-earnings multiples, small caps in Europe are just as cheap right now relative to large caps as they were during the darkest days of the 2008/2009 financial crisis. The valuation premium on European small caps observable in “normal” times on the justifying grounds of higher growth has since turned into a small discount over the past year. A small-cap discount has been in existence in the USA for three years already, even when the pricey Big Tech stocks are stripped out of the equation.

However, the cheapness argument is never a good reason by itself to buy on financial markets. That’s because there’s often a good reason why assets are inexpensively valued. A hoped-for opportunity frequently turns out to be a value trap in hindsight. A look at small caps quickly reveals a few blemishes that may explain their low valuations. To wit, small companies generally tend to be more leveraged with debt loads that are more sensitive to changes in market interest rates and have lower profit margins. Moreover, compared to large caps, a bigger percentage of small-cap companies operate unprofitably. In the past, investors could always ignore those points of criticism whenever they were offset by compensatory high growth rates. Precisely that kind of recovery in corporate earnings may now be on the verge of taking place. Just at the moment when investors have drastically dialed back their earnings expectations and are heavily underinvested, there are good chances that small caps will embark on a turnaround in the quarters ahead.


With a tailwind from the central bank | ECB rate cut = entry signal

Small vs. large on the European equity market (after initial ECB rate cut)

Sources: Bloomberg, Kaiser Partner Privatbank


A combination of several factors makes a case for a turn for the better. Many small caps are so inexpensively valued by now that they are increasingly attracting the interest of strategic buyers (e.g. larger-sized companies or private equity managers). The currently reaccelerating M&A deal market is spurring speculation about imminent share-price upside potential at small publicly traded companies. Another positive development is the ongoing strengthening of economic growth dynamics, particularly in Europe. This should disproportionately benefit small-cap enterprises, which typically operate with higher debt leverage than larger companies do. Last but not least, we are past the peak of restrictive monetary policy by now. A few major central banks have already implemented an initial interest-rate cut. The financing climate for smaller-sized companies soon looks set to tend to become more accommodative. In the past in the European equity space, the kickoff of a new rate-cutting cycle was a sign of an impending rotation into small caps. (Disclaimer: Only three such kickoffs have been observed over the last 25 years.)


In presidential election years, US small caps are… | …often a good choice

Small vs. large on the US equity market (in presidential election years)

Sources: Bloomberg, Kaiser Partner Privatbank


A look at the USA also reveals encouraging data specifically showing that small caps there have outperformed by a median of around 9 percentage points since 1992 during presidential election years. However, apart from this likewise rather narrow statistic (based on just eight observation points), the immediate prospects for American small caps are a bit less favorable compared to Europe. Economic growth dynamics in the USA look set to slow somewhat while the US Federal Reserve continues to postpone an initial interest-rate cut. Moreover, a leadership change from large caps to small caps in the USA depends in large part also on how long AI mania continues. It’s impossible to time that perfectly. Mass investor psychology is unpredictable. However, some of the arguments like the ones below being invoked in favor of large caps in general and Big Tech in particular in the midst of the euphoria don’t hold up well at second glance:

  • Large caps are beneficiaries of artificial intelligence: Although it is true that large companies possess more resources and capital with which to earn a profit on the artificial intelligence megatrend, in the past it has invariably been the smaller contenders that have benefited the most from tectonic technological shifts. The big players are often less adaptive and more resistant to change, and innovations usually affect only a part of their business.
  • Large caps have a competitive advantage: Large companies benefit, in fact, from more than just economies of scale. Megatrends like globalization, the rise of China, the Big Tech phenomenon, and structurally falling interest rates have also made them winners over the last two decades. Looking ahead, though, the future reality for the big players looks set to become much less conducive to profit-making. Deglobalization and reshoring could prove especially disruptive to them. Higher taxes and/or more regulation (e.g. in the technology, telecom, utilities, energy, and healthcare sectors) as a result of actions by increasingly populist governments are also likely to adversely affect large caps in particular.
  • The growth of passive investing makes an outperformance by large caps a self-fulfilling prophecy: Over the past decade, large caps have benefited immensely from the rise of passively managed investment funds (ETFs). However, the price performance of the big stocks by now has become heavily dependent on that very same investment capital. During the next economic downturn, passive capital flows driven more by investor whims than by the fundamentals could cause proportionally bigger drawdowns and higher volatility among large-cap stocks.

If AI-phoria comes to an end and triggers a U-turn, that could definitely happen abruptly. That’s why it makes sense today also in the US small-caps space to build tactical positions in particularly promising stocks on price dips. The risk of further losses relative to large caps is reasonable and manageable at the current valuation level.


The small-cap premium…

Judging by previous cycles, a possible new phase of small caps outperforming large caps would generate at least 20 to 30 percentage points of medium-term alpha potential. However, the situation beyond the medium-term time horizon looks different because the underlying conditions on the capital market have changed radically in recent years for smaller-sized companies (and their shareholders).

For decades, the premium earnable on small caps was an empirically demonstrable “law of nature.” Eugene Fama and Kenneth French looked into this in 2006.1 They discovered that the structural outperformance of small caps versus large caps is attributable to just a handful of single stocks. They experienced such dramatic share-price rises that they transformed from small caps into mid-caps and then into large caps, a phenomenon that Fama and French called “migration.” However, if this migration is stripped out and one adjusts the statistics to take account of the factor “valuation,” the outperformance by small caps turns into an underperformance. The reason is because small companies typically are more prone to go bankrupt or get bought out by other corporations. And even if they “survive,” they mostly deliver a lower performance than large companies do.

The difference thus is made by just a few highly successful companies that advance from the minor leagues of the stock market to the Champions League. Investors who bet on small caps are, in this sense, buying lottery tickets in the hope that a few of them will hit the jackpot. However, over the last 20 years there have been fewer and fewer winning tickets. The migration between stock-size classes has decreased by half since the turn of the millennium. Ever fewer small publicly traded companies are growing big enough for a promotion and are instead staying permanently in the small-cap universe. The small-cap premium has lost a lot of its allure.


A handful of star performers… | …explain the historical small-cap premium

Decomposition of US stock-market performance (for period from June 1927 to June 2006)

Sources: E.F. Fama and K.R. French (2007), Kaiser Partner Privatbank


…is getting undermined

The dearth of star performers among small caps is not because there are no longer any entrepreneurs (or visionaries) these days capable of building successful, feisty companies. Quite the contrary, in fact, the number of young enterprises is perennially growing,2 and the ecosystem for growth companies is more vibrant, dynamic, and sophisticated than ever. But fewer and fewer of these small, fast-growing companies are going public. Whereas IPOs were still the norm prior to the year 2000, in nine out of ten cases these days, the exit by venture capital firms gets done by selling to a strategic buyer or to a competing company. Big Tech has contributed significantly to this trend. Since the mid-2000s, the biggest (US) technology companies have been on a virtually perpetual shopping spree and have acquired hundreds of small firms. The buyout offers from the “big guys” are just too tempting for most startups. Instead of risky and costly competition, an enormous distribution channel, massive customer growth, and huge return potential beckon. This is a major reason why some of the best startups of the last 20 years have ended up in the hands of Alphabet (Android, YouTube, Fitbit), Amazon (Twitch), Apple (Beats Music), Meta (WhatsApp, Instagram), or Microsoft (Skype, LinkedIn). If those takeovers had never happened, many of those enterprises would have evolved into successful small-cap stocks and ultimately would have grown into large caps. By acquiring those startups, the big technology companies didn’t just eliminate competitors that threatened their monopoly power, but also siphoned off the growth that in the past would have accrued to small-cap investors after early IPOs.


IPOs are merely a sideshow | The real action is in the private market

Number of exits from venture capital-funded companies

Sources: National Venture Capital Association, Kaiser Partner Privatbank


Founders who are able to resist the lucrative checks from tech giants also deliberately like to stay away from stock exchanges these days, and that’s not just because staying private means less compliance expenses and controls and shorter decision-making paths for companies. Unlike before, an IPO is no longer necessary even from a funding standpoint because the private capital market is so broad and deep that growth companies can be scaled up to a massive size also this way. The biggest US company owned by venture capital firms – aerospace company SpaceX – by now is more than 40 times larger than the upper market-cap limit set by the Russell 2000 index of US small caps. If SpaceX were to go public, it currently would rank around 40th on the list of the largest publicly traded companies in the USA, ahead of multinational corporations like American Express, Pfizer, and IBM.


Too big for the small-cap index | The average tech IPO today is a large cap

Market cap of tech IPOs in relation to the Russell 2000 index’s upper market-cap limit

Sources: National Venture Capital Association, Kaiser Partner Privatbank


Many successful companies these days still go public eventually, but by the time they do, they usually are already large caps. In recent years, tech IPOs, for example, have been around 50% larger than the biggest small caps in the Russell 2000 index. In the late 1990s, they were only a fifth as large. The importance of small caps to the IPO market generally has continually diminished over the years. Whereas IPOs with issue proceeds of less than USD 100 million accounted for 27% of the total capital raised in the 1990s, their share since the year 2000 (adjusted for inflation) has shrunk to just 7%.3 These developments have significant consequences for investors in small caps. Whereas they were once able to earn massive excess returns relative to the S&P 500 index with companies like Amazon (948%) and Nvidia (557%) during their small-cap phase, profits of that kind were no longer possible with the next generation of companies like Meta, Alphabet, and Tesla. Those companies already belonged to the universe of large-cap stocks on their first day of public trading. Private financiers were the only ones that profited from their early-stage growth.

Second-rate remnants or hidden champions?

Since many of the best companies these days bypass the universe of publicly traded small caps, small-cap indices increasingly risk turning into a repository of rather subpar companies with poor fundamentals or unscalable business models. Strictly speaking, the average quality of small caps – as measured by return on equity, for example – has always been lower than that of large caps, but the quality gap has increasingly widened over the last two decades, and not due solely to the strong fundamentals of large caps. According to an analysis by Verdad Capital,4 the profitability of newly publicly traded small-cap companies has declined. Given the abundance of more attractive financing alternatives available, practically the only companies that choose to go public as a small cap are the ones that don’t have any other options. This means that small-cap indices today suffer from the problem of adverse selection. And investors in small caps run the risk in the end of holding the metaphorical trashcan of the stock market in their hands.


A market for stock pickers | The quality of small caps is declining

Return on equity

Sources: National Venture Capital Association, Kaiser Partner Privatbank


That risk exists for the time being for those who invest passively in small caps via ETFs. For actively managed small-cap strategies, in contrast, there are good prospects even beyond the cyclical medium-term horizon. Academic studies show that many factors and inefficiencies on the equity market are particularly pronounced in the small-cap segment, in large part because small caps do not stand in the spotlight and receive less coverage by analysts. They also show that the wide variance in the quality of companies is not necessarily problematic for experienced portfolio managers and, to a greater degree, is actually a source of significant alpha.

Easily overlooked hidden champions exist particularly in niche markets like Switzerland. Kaiser Partner Privatbank has built up extensive expertise on the Swiss small- and mid-caps segment over the past decade thanks to our closeness to this market. Our Swiss Stocks Basket launched at the start of 2016 has generated sustained added value for our clients, delivering an annualized return of +11.4% and a 5.5-percentage-point outperformance of the benchmark Swiss Performance Index (SPI). Clients of Kaiser Partner Privatbank now can also participate in the performance of the privately held large caps of the future. Our Private Markets Solution enables clients to gain access to privately held venture capital and growth equity firms.


1 Eugene F. Fama and Kenneth R. French, “Migration,” Financial Analysis Journal, 63-3, (48-58), 2007
2 Craig Doidge, G. Andrew Karolyi and René M. Stulz, “The U.S. Listing Gap,” Journal of Financial Economics, 123-3, (464-487), 2017
3 Marshall Lux and Jack Pead, “Hunting High and Low: The Decline of the Small IPO and What To Do About It,” M-RCBG Associate Working Paper Series No. 86, 2018
4 “The Quality of New Entrants,” Verdad Capital, December 2023


Oliver Hackel, CFA Senior Investment Strategist

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