7/27/20 Market Notes
US equity markets ended last week on a negative note with the S&P 500 down -0.28% and the Dow Jones Industrial Average down -0.75%. The Nasdaq led markets lower, down -1.33%, as technology stocks continued to back off from their rally earlier in the month. Heightened US/China tensions and a stalling in additional stimulus negotiations weighed on investors' minds.
Coming into a big week for earnings, U.S. futures are positive this morning with coronavirus stimulus expected to be in focus. Treasury Secretary Steven Mnuchin reported Sunday that the GOP coronavirus relief bill, worth about $1 trillion, was ready to be introduced this morning. The real question is whether or not a bill can find bipartisan support and see passage before Congress’ August recess. Among the companies scheduled to report their quarterly results this week are McDonalds, Pfizer, Alphabet, Apple and AMD.
Classically commanding a size premium, small cap stocks are generally expected to outperform their large cap peers over the long term. Looking at the numbers, however, reveals that this view has been challenged in recent years. Small cap companies had initially outperformed coming out of the Great Recession, but recent pullbacks have left shares depressed. Even before the pandemic, the S&P Small Cap 600 Index still hadn’t fully recovered from the equity selloff in Q4 2018.
So, what’s the deal with small caps? Given their size, small cap companies are generally less flexible than large cap companies and tend to be more economically sensitive. Large companies have better access to financing, seasoned management teams, diversified business models and way more cash at their disposal. Small companies, on the other hand, tend to have more concentrated businesses, more expensive financing and less cash to weather a rainy day. At least theoretically, these increased risks warrant a small company premium that should translate to higher expected returns. While we note the relative underperformance of small companies versus large companies, we see opportunity in this space as we look through the pandemic towards eventual recovery. But where to look? Given such a large pool of potential investments (65% of U.S. listed companies have a market cap below $2.5B) we believe that vetting for quality companies helps significantly reduce “small company” risks while still enabling outsized returns. In our view, this means finding strong secular growers with experience management teams that generate high returns on invested capital and have low leverage ratios. While these companies are less likely to rally as much as small cap indices, their survivability leads to more consistent returns and lower volatility. In conclusion, we remain overweight large cap versus small cap but we acknowledge the opportunities that small cap companies have in economic recoveries. Having said that, we are highly selective when it comes to investing in small companies and believe there is value in a disciplined approach to small cap investing that can deliver attractive risk-adjusted returns. *Source: Index returns calculated by Bloomberg
Disclosures: This market commentary is written by the 1879 Advisors® and represents the views of 1879 Advisors®. This commentary is not investment advice and should not be used as a basis to make investment decisions. Please consult with your registered investment advisor before making any investment decisions.