INVESTMENT PERSPECTIVE

A Radiant Take on the Opportunities in Small Cap Investments

In the face of what looks to be a changing interest rate environment and a massive valuation spread between large and small cap stocks, there have been a spate of recent ‘why US Small Cap now?’ articles. We’ll get to the ‘now’ in a minute, but first we’d like to answer the bigger picture, ‘why US Small Cap?’

When we launched Radiant three years ago, we set ambitious goals for ourselves.  Among them, we sought to demonstrate that our active, systematic investment process could help us uncover opportunity at the intersection of attractive fundamentals and ESG – or as we would phrase it today, help us uncover truly sustainable companies – to beat the market and outperform other small cap managers. Nowhere is this more challenging than in smaller capitalization stocks as the available information is much thinner. But nowhere is the reward potentially greater as the lack of analyst coverage combined with the rampant use of ‘ESG Ratings’ points to greater inefficiency. We chose to launch our first live strategy in the US small cap space because we think we can add significant value by rolling up our proverbial sleeves and really trying to understand the full set of threats and opportunities faced by smaller companies.

The long run case for small cap is something that we have explored in past essays (here and here); the opportunity has not waned, in our minds, and has perhaps only grown stronger. Small Cap is still an exciting space where innovation lives.  Given the long-run needs of the US economy, smaller stocks are well poised to benefit from initiatives to transform the nation’s infrastructure, to modernize our energy grid and water technology, evolve our methods of transportation, and revolutionize the way we deliver healthcare. While there are important exceptions, US smaller companies are ‘for America by Americans’. By this we mean that many are companies with US operations providing products and services to US consumers directly and/or to larger US firms. Regardless of which political party wins the White House and Congress in November, we believe that the theme of ‘American resilience’ will prevail, in part because of anticipated onshoring (or re-shoring) and continued domestic spending related to the Inflation Reduction Act[1], the CHIPS Act, and other domestic infrastructure spending initiatives.

So why US Small Cap now?  We agree with the assessment of many that the time seems to be right for allocations to US small stocks. Across any number of valuation spreads, we see US Small Cap at discount levels not witnessed for decades[2], in large part because of the high interest rate environment of the last few years, reflecting the greater sensitivity of smaller companies to higher rates. With the meaningful recent downtick in inflation print, we anticipate one (if not two) rate cuts this year, working as a catalyst to close the valuation gap, benefitting smaller capitalization names[3]. Finally, the dominance of the Magnificent Seven[4] in recent years means investors with exposure to the US equity market are dramatically overexposed to a very small handful of mega-capitalization companies. An allocation to US smaller stocks represents a way to continue to participate in US domestic equities, but diversify away from the tech behemoths that may indeed not be the market leaders in the years to come.

In sum, as active managers, we chose US Small Cap as our first investment strategy because it is equal parts exciting and inefficient. We see significant upside in companies that are poised to meet the future needs of the US domestic economy, and believe that our novel approach can uncover opportunity that others might miss. ‘Why Small Cap?’ is an easy question for us to answer, given the long-run attractiveness of the asset class and our ability to work in the details. ‘Why Small Cap now?’ is equally straightforward: valuations are at an extreme, and a tick down in interest rates could be a catalyst for a broadening of the US equity market and a rotation into smaller stocks. And the diversification benefits of US small stocks are the icing on the cake for investors.

[1] While we would expect a roll-back of certain specific provisions of the IRA under a Trump administration (e.g. EV tax credits), our belief is that most of the Act would remain in place primarily because, at a state level, Republican strongholds are key beneficiaries: Red States Benefit Most From Biden’s Inflation Reduction Act | Markets Insider (businessinsider.com), and Red states are big winners of Biden’s landmark laws | CNN Business.

[2] On a Price/Forward Sales basis, the discount of small caps relative to large caps is at a level not seen since 2001.  Source:  Bloomberg, ‘Small Caps’ Discount to S&P500 Hits Historically Steep Level’, June 2024.

[3] Historically, smaller capitalization stocks have done well in high but declining interest rate environments.

[4] ‘The Magnificent Seven’ referred to here is in fact not the 1960 western by John Sturges (though the film is worth a look: The Magnificent Seven (1960) – IMDb), rather the collection of the largest US mega cap companies: Apple, Microsoft, Alphabet, Tesla, Nvidia, Meta, and Amazon.