Small-caps: When quality counts, cheap valuations aren’t enough

Quick takes on capital markets

October 27, 2023 | 2 min read

U.S. small caps recently broke below their pre-pandemic level and have vastly underperformed the largest 50 stocks in the Russell universe. Although buying when markets are cheap is generally preferred, today’s small-cap valuations appear entirely justified, if barely sufficient, when considering their weaker profits outlook and greater exposure to higher interest rates. Investors should maintain their preference for high-quality large caps, which are better positioned to weather a slowing economy in 2024.

Russell Top 50 Index versus Russell 2000 Index
Level, January 2020–present

Line graph

Note: Russell Top 50 Index comprises the largest stocks by market cap in the Russell 3000 index.
Source: FTSE Russell, Bloomberg, Principal Asset Management. Data as of October 26, 2023.

It has been 19 months since the Federal Reserve embarked on its interest rate hiking campaign, and its lagged effects have yet to fully emerge. While the U.S. economy has shown resilience and delivered upside surprises, market bellwethers like small-cap stocks have not been so durable.

In glaring contrast to the largest 50 stocks, which have advanced almost 40% since their pre-pandemic highs, small-caps are now back below their pre-pandemic levels. Although small-cap underperformance has delivered tempting valuation discounts, this alone is likely to be insufficient when considering the stark difference in earnings outlooks. The largest 50 stocks are expected to grow earnings by 5 percent in 2024, versus a 7 percent contraction for small-caps.

From here, monetary tightening will increasingly challenge small-caps, as they are more dependent on free-flowing credit, and more vulnerable to higher interest rates. High-quality large-caps are comparatively immunized, with positive cashflow businesses being better placed to withstand higher rates. Large-caps’ superior profitability and more liquid balance sheets are quality distinctions which merit recent outperformance.

While “cheaper” small-caps may appear enticing to investors, their underperformance and current valuations appear justified given the challenging profits backdrop, their weaker balance sheets, and greater credit dependence. In anticipation of a slowing economy in 2024, investors should focus on quality fundamentals and continue to favor high-quality large-cap equities.

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