Trevor Gurwich

Attractive earnings growth prospects and discounted valuations due to recent, uncharacteristic underperformance may create opportunities for global small-cap stocks.

Key takeaways

Rising interest rates proved to be a strong headwind for global small-caps and other longer-duration risk assets, but those trends may be reversing.

Analysts forecast that 2024 earnings for small-cap companies will grow faster than large-cap earnings in most regions.

Increasing M&A activity and attractive bottom-up opportunities tied to cybersecurity, nearshoring and travel contribute to our positive outlook for global small-cap companies.

Macro events have overshadowed company fundamentals

Global small-cap stocks have borne the brunt of worries about inflation, rising interest rates and slowing economic growth over the last three years. Even though returns have been positive, the steady climb in the U.S. 10-year Treasury yield since the end of 2021 has also worked against small-caps, especially growth-oriented stocks.

Despite somewhat resilient corporate earnings, the trend continued in 2023 with small-caps underperforming large-caps by a wide margin, particularly in the U.S. However, as shown in Figure 1, this period of relative weakness has been an exception compared to a record of small-cap outperformance since 2001.

As we open 2024, indications that inflation is easing have again raised hopes for a sustained pause in global central bank rate hikes. We believe this could produce a more favourable backdrop for global small-caps and allow investors to refocus on earnings growth as the key driver of stock prices.

Figure 1 | Large-Caps Have Narrowed the Gap but Still Trail Small-Caps Over the Long-Term
MSCI ACWI Small-Cap vs MSCI ACWI Large-Cap

Data from 1/1/2001 – 12/31/2023. Source: FactSet. Past performance is no guarantee of future results.

Three reasons for an upbeat outlook for global small-caps

1. Attractive valuations

Despite recent headwinds, we think the long-term case for small-caps is intact. Furthermore, we believe the historically low valuations for global small-caps relative to their large-cap peers are especially compelling, as shown in Figure 2.

Figure 2 | Current Valuations for Global Small-Caps Are Historically Low
MSCI ACWI Small-Cap vs MSCI ACWI

Data from 1/31/2014 – 12/31/2023. Source: FactSet. Past performance is no guarantee of future results.

2. Stronger profit growth

Based on consensus earnings per share, we expect small-cap profits to grow faster than large-cap profits in most regions in 2024. In addition, the headwinds of rising interest rates faced by small-caps — especially small-cap growth stocks — appear to be on track to diminish or reverse.

Such a shift could enable investors to turn their focus from central bank policy to corporate profits, creating a more favorable environment for active security selection. Longer-term, we believe investors will reward companies with improving earnings growth.

3. More merger and acquisition activity

Global merger and acquisition (M&A) activity in 2022 and 2023 was near 25-year lows, which may result in pent-up demand for deals by acquirers. We may see a positive turn in activity in 2024 as financing visibility improves and larger firms seek to boost organic growth rates. An improving outlook for M&A activity tends to translate to a favorable backdrop for small-cap investors, as small companies can be key beneficiaries of M&A.

Trends driving profit growth

Travel spending

Healthy travel-related spending may benefit consumer discretionary stocks like Samsonite, the global luggage manufacturer. The company’s earnings growth has been driven by strong demand for its higher-margin Tumi brand, which accounts for over 20% of sales, and strong growth in Asia.

Improving earnings has also allowed the company to reduce its debt significantly and strengthen its balance sheet. Despite consistent positive earnings revisions, Samsonite’s valuation has contracted and now trades at only 10x forward earnings per share.

Increased demand for logistics and cybersecurity software

Companies benefiting from increasing spending on logistics software and cybersecurity include Kinaxis, a logistics software company, and Tenable and CyberArk, cybersecurity companies. We also believe our cybersecurity-related holdings are beneficiaries of artificial intelligence (AI).

Adopting AI will likely lead to a greater frequency and higher sophistication of cyberattacks, requiring companies to spend more on protecting their networks. We also believe Tenable — as a market leader in the space and with a proven track record of product innovation — has the potential to outgrow the overall market and continue to expand its total addressable market.

Nearshoring and infrastructure spending

Companies benefiting from accelerating growth tied to nearshoring and infrastructure spending include Canada-based Stantec, a global leader in sustainable engineering and environmental consulting. Among other growth areas, Stantec has won several contracts for designing and constructing battery plants in North America and contracts tied to infrastructure and wastewater solutions.

Potential volatility doesn’t diminish the opportunities

Slower-than-expected economic growth remains a risk because small-caps tend to lag large-caps early in recessions. However, we’ve already seen more significant underperformance of small-caps versus large-caps compared to the average of previous recessionary and bear-market periods.

While near-term volatility is possible, we continue to identify small-cap companies that we believe have the potential to deliver accelerating and sustainable earnings growth. Stable or declining interest rates may continue to provide a tailwind for small-cap markets.

We believe bottom-up stock selection and prudent diversification remain critical as we continue to find growth opportunities across various sectors and geographies.

By Trevor Gurwich, senior portfolio manager and Jim Shore, senior client portfolio manager

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