Small Caps Get Earnings Support

Following a five-year period of large cap dominance, small caps appear to be amid a resurgence, with a year-to-date return of 0.7% in the Russell 2000 Index compared to a decline of 5.1% for the S&P 500 Index.¹ While small caps have not been immune to the recent volatility caused by the outbreak of war in the Middle East, we believe this nascent revival may have durable support from a sustained acceleration in earnings.

Small cap earnings growth is expected to accelerate to an annual rate of 27.1% over the next three years following nine years of 3.9% annualized earnings growth, as shown in the chart below.² Such earnings would be supportive of improved small cap performance even without multiple expansion; meanwhile, with the Russell 2000’s forward P/E of 18.0x well below the S&P 500’s 21.8x, valuations provide a favorable risk-reward backdrop for small caps.³

In the face of a prolonged oil shock, we note that inflationary periods historically have not been a death knell for small caps.⁴ Smaller companies typically have a much larger domestic revenue base, and the US economy is less sensitive to global oil shocks compared to economies that are reliant upon energy imports.

Amid such fertile grounds, we believe it’s vital to distinguish between companies that are cheap for a reason from those with solid businesses and catalysts for improvement.