Upside Potential of Small Cap Equities

In the equity market, we can generally divide the stocks into three different categories by their market capital(cap): large-cap, mid-cap and small-cap. Among the large-cap stocks are some of the most famous names, like Apple, Walmart, Ford, etc.

How has the equity of the large-cap companies performed compared to the rest of the market then? As of December 15th, The NASDAQ 100 Index, representing the largest 100 companies on the NASDAQ Exchange, has increased by 52%—while the Russell 2000 Index, comprising about 2000 small-cap companies in the US market, has only gone up by 14%. There is now a new name for Apple, Alphabet (Google), Microsoft, Meta, Amazon, Nvidia and Tesla—the largest companies on NASDAQ measured by market cap—as a group called the Magnificent 7 given their astonishing average return of 70% year-to-date. 

Provided with the numbers above, you might think that large-cap equities, especially the Magnificent 7, are therefore great investments compared to small-cap equities. Obviously, they would have been fantastic if were bought at the beginning of the year, but are they still? Perhaps this graph will give you some idea: if we divide the Russell 2000 by the NASDAQ 100, we can look at how the two indices have moved compared to each other over the years.

In portfolio management, there is this strategy called asset class rotation. The idea is to switch the portfolio among the different asset classes (large cap, mid cap, small cap) from time to time to outperform the broad market, since, in theory, the underdog tends to outperform in the forthcoming years and vice versa. In the graph above, we can easily identify that small-cap equities have been an underdog over the last decade. In contrast, the Magnificent 7 have been growing at arguably unreasonable rates—the seven companies recorded average year-over-year revenue growth of 39% (11% without Nvidia), while the average 1-year equity return reached 93% (77% without Nvidia). 

You might argue that the NASDAQ 100 or the S&P 500 include much more companies than the Magnificent 7, but be aware that these indices are weighted by their member's market cap—the market cap of the Magnificent 7 is now nearly 30% of the S&P 500 index. If you believe in mean reversion and that history will repeat, then the small cap is set to outperform the large-cap over the next year.

Another tool we can use to help answer the question is yield. Provided that the value of any asset is the sum of its discounted future cash flow, the free cash flow figure makes a good measure of firm value. If we flip the P/FCF ratio into FCF/P, we get another valuation metric called free cash flow yield. Similar to dividend yield (dividend/share price), free cash flow yield represents an annual rate of return, only that dividend yield represents the return coming from dividend payments, while free cash flow yield represents the return of the entire firm. 

Yields are especially useful measures to look at in the current rising-interest-rate environment—you can compare the yields across the board to tell which investment looks more attractive. For example, the 1-year UK government bond, which is nearly risk-free, is currently yielding above 4%. If you see an equity’s free cash flow yield is at, let’s say 3%, then it would seem unreasonable to invest in the equity—why would you pick a risky investment that expects a 3% return while you can enjoy a 4% return that causes you no worry? With that said, you have probably realised that a higher yield is a sign of undervaluation and vice versa.

Despite the stronger-than-average fundamental growth of the Magnificent 7, their average trailing-12-month free cash flow yield is at an alarming 2.53%—indicating a 76% premium compared to the 2-year US Treasury, a risk-free investment, yielding at 4.46%. 

In conclusion, equity investors should look for equities in the small-cap asset class with high yields. Given the current high interest rates and slow economic growth, large-cap equities represented by the Magnificent 7 are most likely overvalued and tend to underperform in the coming year, as suggested by the free cash flow yields. Considering the performances of the year, we anticipate the addition of small caps and the removal of large caps from portfolios as rebalances occur going into 2024.

Disclaimer: The statement provided are based solely on the opinion of the author and are being provided for general informational purpose only. Please be sure to consult with a professional financial advisor before making any investment decision.