Welcome to Soundbites, weekly insights on market trends and investment strategies, brought to you by Investment Executive and powered by Canada Life. For today’s Soundbites, we’re talking about cap-size strategies with Jack Manley, vice-president and global market strategist with J.P. Morgan Asset Management. We talked about performance and profitability, and we started by asking why he thinks small-cap stocks will benefit from broadening economic strength.

Jack Manley (JM): Historically speaking, small caps have disproportionately benefited from two key macro tailwinds that don’t benefit large-cap stocks nearly as much. One of those things is going to be a strong U.S. economy. Small-cap names typically only do business in the U.S. So the health of the U.S. economy matters a lot more for them. The other thing is a strong U.S. dollar because so many of the products they sell are procured from outside of the U.S. So when I think about these two things and what the odds are of them reversing so significantly that they become headwinds for small-cap names, that’s not something I’m particularly worried about right now.

Performance expectations

JM: 2024 is looking to be a pretty good year for profit growth across the board. Analysts are looking right now for earnings-per-share growth out of the S&P 500 of 12% — a pretty significant upswing in sentiment. Now, you move down a little bit in the cap space, mid-cap stocks are expected to post 8% year-over-year growth of profits in 2024, following an 8% year-over-year growth in profits in 2023. And small caps are looking for a very significant reversal of fortune. We actually saw small-cap earnings decline by 10% in 2023. We’re looking for them to grow about 23% in 2024.

Profitability

JM: The elephant in the room when it comes to profitability is that 41% of the Russell 2000 is unprofitable. Almost half of the index doesn’t make any money. And that is shocking. We have to take it as almost a side effect of the interest rate environment that dominated, really between the end of the financial crisis and the start of the pandemic. Interest rates were at zero. Borrowing money cost almost nothing. That 0% interest rate environment is one of the reasons so much of the small-cap index is unprofitable. It didn’t have to be profitable to draw investor attention. And it would be a lot harder to generate profitability when money actually cost something. Now, mid-cap names are going to be doing a little bit better; 17.5% of those names are unprofitable. So figure about of a fifth of the index. Large-cap names [are] doing a whole lot better. Less than 8% of that index is unprofitable.

Debt servicing

JM: There are big differences in debt composition between the largest and smallest names in the public U.S. equity market. Roughly half of S&P 500 outstanding debt matures after 2030, compared to only about 14% of outstanding debt in the Russell 2000. Everything else with the Russell 2000 matures before 2030. What that means is that the maturity wall, so to speak, is a whole lot bigger and it’s a whole lot closer for small-cap names, which makes them a lot more sensitive to refinancing risks. We also know, in terms of debt composition and the kind of debt that was issued, that only about 6% of S&P 500 debt is floating rate, whereas nearly 40% of Russell 2000 debt is floating. And so not only are small-cap companies that have maturities that are fixed, dealing with real refinancing risk, those small-cap companies that have floating rate instruments have been sort of smacked across the face every single step along the way as the Federal Reserve has tightened screws and raised interest rates over the last few years. This has been disproportionately punitive to those small-cap names.

And, finally, what’s the bottom line on assessing merits of large-, medium-, and small-cap companies?

JM: My role as a global market strategist is basically, you coming to me, handing me a dollar, and saying, ‘Put this dollar into small-cap or large-cap or mid-cap.’ And I elect to allocate to large-cap stocks for all the reasons that we just went through. Regardless of where you’re looking — large, mid, or small — the emphasis has to be on security selection, because when we’re thinking about all these problems, they do not apply universally to every company. There will always be winners and losers. Being able to identify those and isolate them, that’s what’s going to be critical to investing success, regardless of where you are on the cap spectrum.

Well, those are today’s Soundbites, brought to you by Investment Executive and powered by Canada Life. Our thanks again to Jack Manley of J.P. Morgan Asset Management. Visit us at investmentexecutive.com, where you can sign up for our a.m. newsletter and never miss another Soundbite. Thanks for listening.

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