The pandemic and beyond: playing to small-caps’ strengths?

Most asset classes have performed well during the journey out of the COVID-19 crisis, yet small-caps’ trajectory is uniquely eye-catching. Although there has been variation between regions, as figure 1 illustrates, the MSCI ACWI Small Cap Index has comfortably outstripped its All Cap counterpart since the bear-market low of March 2020.

In the run-up to the pandemic, by contrast, it was large-caps that enjoyed a spell of dominance. This was in part attributable to the pre-eminence of Big Tech, most notably in the US but also in areas of Asia. So why have small-caps risen to prominence so spectacularly amid the tumult of the past year?

“Small-caps typically do well coming out of crises or recessions,” Erik Esselink, Global Small Cap Fund Manager, told the webinar. “Historically, they tend to perform strongly during the early stages of a recovery – and we see no reason why this time should be any different. The question, of course, is whether they can continue to perform strongly.”

Esselink suggested small-caps’ ability to generate faster growth – in terms of both revenues and earnings – would be vital to maintaining their recent outperformance. “A smaller company with $10 billion in revenues can grow by 10% more easily than a larger company with $100 billion in revenues,” he said.

M&A activity could also contribute. “Remember that we sit between private equity and large-caps,” Esselink told the webinar. “Sometimes we buy from private equity, and sometimes we sell to private equity. Sometimes we take companies financed by larger enterprises, and sometimes we sell to larger enterprises. The M&A cycle can be a big driver for small-caps, and we think it’s about to take off.”

Finally, Esselink highlighted the “self-correcting” nature of small-cap index composition. A large-cap that grows and grows merely assumes an ever-greater weighting in its index, but a small-cap that grows and grows eventually leaves its index – meaning it is unlikely to have a weighting big enough to pose problems in the event of an unforeseen, idiosyncratic shock.