Insights / March 28, 2024

Is It Time for a Changing of The Guard?

Wasatch Portfolio Manager and CEO JB Taylor Discusses the Potential for a New Small-Cap Cycle

Q: Are markets poised for a new cycle of small-cap leadership?

JB Taylor: As long-term investors in small-caps, we never try to time a small- or large-cap cycle. And we’ll be the first to admit no one can predict such things with precision. However, there’s a lot of data suggesting a change in market leadership could be on the horizon. Some of those key data points include the length of the current large-cap cycle, small-cap valuations relative to large-caps and the concentration of large-cap indexes.

Q: Just how long has the current large-cap cycle been ongoing?

JB Taylor: Each period is different, but a large- or small-cap market cycle can stretch past a decade and often run 11 or 12 years. The current cycle, now starting its 14th year, isn’t just longer than average. It’s among the longest cycles for either market-cap segment in nearly 100 years.

Q: What are you seeing in terms of large-cap and small-cap valuations?

JB Taylor: Broadly speaking, we’ve rarely seen small-caps this attractive relative to large-caps. The following chart shows how the valuations of the two market-cap segments have compared over time. Currently, relative valuations for small-caps are hovering near their lowest level since the beginning of the last small-cap cycle almost 25 years ago.

The next chart shows how the P/E ratios of the Russell 1000 and Russell 2000 have changed over the past decade. It also shows the rapid expansion of the P/E ratio of the Magnificent Seven: Apple, Microsoft, Amazon.com, Alphabet (Google), Tesla, Nvidia and Meta Platforms (Facebook). We broke out the valuation of the Magnificent Seven because we see the dominance of these seven companies as another potential risk for large-cap indexes. Notably, while the P/E ratio of the Russell 1000 has expanded—and the P/E ratio of the Magnificent Seven has expanded substantially—the valuation of the Russell 2000 has shrunk!

Q: How have corporate earnings fared for smaller companies?

JB Taylor: Our companies’ earnings growth has been exceptional, in our view. On average, companies in our U.S. Small Cap Core Growth strategy grew earnings at an annualized rate of 23% over the past five years. But here’s what’s unusual: The steady earnings growth hasn’t been reflected in the recent stock prices of these companies.

Over longer periods, stock prices tend to track revenue and earnings growth. While cumulative stock returns have periodically deviated from the trend in earnings growth, as they have today, they’ve generally come back into rough alignment. Based on our experience, we think the current gap between stock returns and our companies’ revenue and earnings should eventually close—with performance accruing in our favor.

Q: You mentioned large-cap indexes are unusually top-heavy. How concentrated have they become?

JB Taylor: Large-cap indexes are more concentrated than at any point in at least 50 years thanks to the dominance of the Magnificent Seven. A few stats underscore how remarkably large the Magnificent Seven companies have become:

  • The Magnificent Seven stocks comprise roughly 30% of the S&P 500 Index’s entire market capitalization.
  • The market capitalization of the entire Magnificent Seven is nearly four times as large as that of the Russell 2000 Index.
  • Two companies—Apple and Microsoft—each have a market capitalization nearly as large as the entire Russell 2000 Index.

The following pie charts illustrate the growth of the Magnificent Seven over the past decade, showing the individual company market capitalizations versus the market capitalization of the Russell 2000 Index.

Q: Why is a top-heavy index potentially negative for large-caps?

JB Taylor: While the Magnificent Seven are innovative and highly successful companies, with an aggregate P/E of 30 times earnings, they also have high valuations. As growth investors, it’s not uncommon for us to find a stock attractive that has a P/E of 25 or 30. But we’d expect these small-cap companies to double earnings in five years and double earnings again in the next five years. Put another way, we expect the earnings of these companies to grow four-fold over a decade.

In our view, it may be difficult for the Magnificent Seven to achieve this type of growth over the next 10 years. The companies would have to produce revenues that equate to roughly 25% of the entire U.S. GDP. If that type of growth proves untenable, it could weigh heavily on the stock prices of the Magnificent Seven, and in turn, bode poorly for large-cap indexes.

Q: When do you think small-caps will lead markets again?

JB Taylor: It’s impossible to predict precisely when a new small-cap cycle will occur. However, market data suggest that the groundwork has been laid for a changing of the guard. At this point, some small-cap index levels are at a 22-year low relative to large-cap index levels. Put another way, the performance of the Russell 2000 relative to the Russell 1000 hasn’t been this poor since roughly the start of the last small-cap cycle.

No one can time the start of a new small-cap cycle perfectly. But investors considering a small-cap allocation may want to get it in place now, as a change in market leadership could be both swift and dramatic.

 


RISKS AND DISCLOSURES

Information in this document regarding market or economic trends, or the factors influencing historical or future performance, reflects the opinions of management as of the date of this document. These statements should not be relied upon for any other purpose. Past performance is no guarantee of future results, and there is no guarantee that the market forecasts discussed will be realized.

Wasatch Advisors LP, trading as Wasatch Global Investors, ARBN 605 031 909 is regulated by the U.S. Securities and Exchange Commission under U.S. laws which differ from Australian laws. Wasatch Global Investors is exempt from the requirement to hold an Australian financial services licence in accordance with class order 03/1100 in respect of the provision of financial services to wholesale clients in Australia.

As of March 31, 2024, no Wasatch strategy was invested in Apple, Microsoft, Amazon.com, Alphabet, Tesla, Nvidia or Meta Platforms. Portfolio holdings are subject to change at any time. References to individual companies should not be construed as recommendations to buy or sell shares in those companies. Current and future holdings are subject to change and risk.

DEFINITIONS

The Russell 1000 Index measures the performance of the largest 1,000 companies in the Russell 3000 Index. The Russell 1000 typically comprises about 92% of the total market capitalization of all listed stocks in the U.S. equity market. It is considered a bellwether index for the performance of large company stocks.

The Russell 2000 Index is an unmanaged total return index of the smallest 2,000 companies in the Russell 3000 Index, as ranked by total market capitalization. The Russell 2000 is widely used in the industry to measure the performance of small company stocks.

The Russell 3000 Index measures the performance of the largest 3,000 U.S. companies representing approximately 98% of the investable U.S. equity market.

The S&P 500 Index includes 500 of the United States’ largest stocks from a broad variety of industries. The Index is unmanaged and is a commonly used measure of common stock total return performance.

The CRSP 6-8 Decile Index is a small-cap index created and maintained by the Center for Research in Security Prices (CRSP) at the University of Chicago’s Graduate School of Business. CRSP capitalization-based indexes include common stocks listed on the NYSE, AMEX, and the NASDAQ National Market.

Indexes are unmanaged. Investors cannot invest directly in an index.

The Wasatch strategies have been developed solely by Wasatch Global Investors. The Wasatch strategies are not in any way connected to or sponsored, endorsed, sold or promoted by the London Stock Exchange Group PLC and its group undertakings (collectively, the “LSE Group”). FTSE Russell is a trading name of certain of the LSE Group companies.

All rights in the Russell indexes vest in the relevant LSE Group company, which owns these indexes. Russell® is a trademark of the relevant LSE Group company and is used by any other LSE Group company under license.

These indexes are calculated by or on behalf of FTSE International Limited or its affiliate, agent or partner. The LSE Group does not accept any liability whatsoever to any person arising out of (a) the use of, reliance on or any error in these indexes or (b) investment in or operation of the Wasatch strategies or the suitability of these indexes for the purpose to which they are being put by Wasatch Global Investors.

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