Famous musician Prince encouraged us to “Party Like It’s 1999,” but today, as a small-cap stock investor, I’ll turn the calendar forward a year to 2000.
This is because by March 2000, the NASDAQ had peaked at 5048 and by April had fallen nearly 35%. There were no parties for the next 18 months. Several formerly high-flying tech stocks lost all or nearly all of their value, including Pets.com and Priceline.
Even giants like Intel (INTC), Cisco (CSCO), and Oracle (ORCL) suffered big declines. In fact, trillions of dollars evaporated during this infamous period known as the dot-com bubble.
But for some investors, the best time to deploy capital was after the dot-com bubble. This was an extremely rare opportunity to gain meaningful positions in quality companies for which there was no appetite in the market.
I believe quality small caps remain in a similar position today.
These days, small caps are disliked, unwanted and uninvited to the party. And there has been a party – a big party thrown by a handful of mega-cap tech stocks, especially those considered to be the pioneers of all things artificial intelligence (AI).
The parallels between the AI craze and the dot-com era are hard to ignore. In 1999, any company that boasted Internet credibility was a market darling. Spoiler alert: It doesn’t end well.
Still, it was an excellent time for selective stock-picking, and there are familiar echoes in today’s Canadian small-cap technology stocks.
What’s happening now – why the big discount?
In life, as in investing, everything happens for a reason or multiple reasons. And this is true for the absolute and relative undervaluation of small-cap stocks.
1. Large pools of capital are increasingly becoming private
Pension funds and other large institutional investors are looking to generate alpha. In the past, they used to allocate a portion of their investments to small-cap public companies to achieve this.
Today, these investors are shifting their portfolios from public markets to private markets. When only a few stocks are generating most of the profits, asset managers have difficulty achieving outperformance.
Therefore, the diversification benefits of private equity and its alpha potential look attractive. For example, Yale University’s endowment fund today accounts for about 40% of private equity and venture capital funds, compared with only 5% in 1990. As the demand for small-cap stocks is declining, their valuations are also declining.
2. Investors are chasing performance
We’ve all heard of the Magnificent Seven, the mega-cap tech stocks that have driven recent equity returns: Nvidia (NVDA), Microsoft (MSFT), Amazon (AMZN), Apple (AAPL), Alphabet (GOOG). (GOOGL), Tesla (TSLA), and Meta (META).
To put things in perspective, Apple is worth more than all the small US companies included in the entire Russell 2000. Investors are chasing large-cap returns, and NASDAQ has an excellent five-year track record. This was true even in January 2000.
3. There are macro and micro
On a macro level, the small-cap market turned around in 2021 and has been facing headwinds for almost 2.5 years now. Rising interest rates were priced in based on small-cap valuations, and with different debt dynamics from their larger peers, smaller companies are typically the first to sell off ahead of a potential recession.
Smaller companies, especially in early growth stages, tend to carry more debt, and that debt has a shorter average maturity – 5.7 years versus 8.2 years – which puts them at greater risk in a tight monetary environment. Smaller companies also have fewer sources of financing to rely on.
What are upside catalysts?
In this backdrop, where are the opportunities in small-cap stocks? Smaller companies tend to lead the way in recovery. When monetary policy becomes more accommodative, perhaps as early as Q1 2024, small-cap equities should respond strongly.
As the performance lead continues to narrow, institutional funds, among other investors, will begin to look elsewhere, and quality small caps are one place where they will likely deploy capital.
Because small caps tend to be less liquid, an increase in demand could potentially generate significant share price moves and re-ratings. Mean regression dictates that, at some point, small-cap valuations will return to their long-term average.
The M&A market is another source of potential upside for small caps. Today, it is difficult to find willing sellers. Many quality companies came to market at high valuations, and management teams have psychologically latched onto those high multiples.
But over time, their shareholders and board members will accept the new reality and realize that acquisitions may be the best path for continued growth.
The small-cap premium has historically meant that small-cap stocks outperform their large-cap counterparts over the long term. For example, from 2000 to 2005, following the telecom boom and recession, the S&P 600 outperformed the S&P 500 by an average of 12% per year. We are in a period of multiple compression in small caps compared to large caps.
As of September 2023, the S&P 600’s Forward P/E is 13.8. The last two times the S&P 600 had a Forward P/E in this range were during the global financial crisis (GFC) and at the beginning of the global pandemic.
On both those occasions, investors who invested in small caps were handsomely rewarded. A similar opportunity can be found even today.
Disclaimer: Please note that the content of this site should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of the CFA Institute.
editor’s Note: The summary bullets for this article were selected by Seeking Alpha editors.