It's because the interest rates are higher now. Small caps are generally more levered which with increasing interest rates leads to lower profits and challenges with balance sheets.
Additionally, smaller companies rely more heavily on borrowing capital to grow, meaning they typically have a larger debt burden. More debt may mean more interest rate risk, given that small caps tend to take out more floating-rate loans than large caps.
It is simply the panic. Small cap companies suffer from poor liquidity ( low volumes traded in the stock exchange). The small cap companies not only fall but they hit the lower freeze, as there will be no buyers. It is easy for operators to manipulate the small cap stocks , pumping and dumping.
2025 outlook: Small caps offer an inexpensive way to gain exposure to the robust US economy. Multiple favorable trends – including onshoring and increased CAPEX – may explain why Wall Street expects to see the strongest earnings gains come from small caps in 2025.
Small-cap valuations – Attractive
We expect earnings to drive the next leg higher for small-cap share prices. Analysts are looking for robust earnings growth: 15% this year, and by over 30% in 2025 and 2026. That is ahead of the long run rate of 13% growth (see Exhibit 3).
As of October 19, 2024, the small cap index was overvalued at a Price-to-Earnings (P/E) of 33.39, while the 3 year long term average stands at 24.49. But experts think there are certain sectors within the small cap that are fairly valued.
The overall quality of publicly traded small caps has deteriorated, as private sponsors help top performers stay private for longer. Instead of small caps, investors should consider actively adding exposure to U.S. large-cap value and mid-cap growth stocks.
Small-cap mutual funds are ideal for you if you have an investment horizon of five years and above, as small-cap stocks are volatile in the short term, and small-cap funds perform better in the long term.
Not only have small-cap stocks historically outperformed their larger peers, but they've done so strongly, by an annual average of more than 300 basis points (bps), and consistently, more than 69% of the time (Figure 1).
Given the changing macroeconomic backdrop, we outline why we see potential value for investors in small caps in 2024. The consensus is that interest rates look to have peaked, with markets now pricing in cuts across many major economies in 2024, something which could prove beneficial to small caps.
Most investors think smaller companies underperform in a recession. In most cases, they are correct. However, what's less well-known is that small caps usually exit recessions quicker than assumed – outperforming large caps. This rebound can begin as early as three months into an economic downturn.
Rebound Potential: The initiation of rate cuts by central banks, signalling a move towards a more normalised interest rate environment, could reduce the performance gap between small and large cap stocks. This environment may favour small cap stocks, indicating a potential rebound.
Small caps struggled with a two-year rate hiking cycle that raised their debt financing costs, as well as growing concerns the U.S. was headed for a recession.
However, the highly overstretched valuation of large-cap stocks, together with a few positive developments may shift market participants' preference from large to small-cap stocks. At this stage, we recommend small cap stocks with a favorable Zacks Rank that have strong growth potential for 2025.
Undervalued small caps have been reliable performers over the long term. Over the last 22 years, for example, small caps have delivered an average total return of 8.1% per year. Of those years, only seven were negative; in half of the years, the asset class posted a total return greater than 10%.
Nifty Smallcap 100 index has fallen 4% to its lowest level since mid-June amid concerns about Q3FY25 performance. Disappointing earnings results have led to increased selling pressure, with many stocks down significantly from their 1-year highs and foreign investors pulling out funds.
Hence, you may incur losses if you wish to withdraw or redeem your investment from the said small-cap mutual fund. Of course, that is not to say that gains cannot be made, but the risk always looms. That's why it always pays to stay invested in a small-cap fund for at least five to six years.
Market experts recommend that investors hold small caps for at least 10 years to benefit and allocate 8% of the portfolio to small caps.
Small caps are more economically sensitive and thus often underperform in late-cycle environments. Small caps have more leverage and floating-rate debt and are therefore more exposed to higher interest rates.
Risk. Small-cap mutual funds are very risky. This means that in the short term, investing in them could lead to short-term losses. If you cannot tolerate seeing negative returns on your investments at specific periods, you should stay away from small-cap funds.
Key takeaways:
U.S. small-cap stocks are showing renewed performance strength. We believe factors behind the shift – including broadening economic growth, moderate inflation, and easing monetary policy – have staying power for 2025.
In July 2024, U.S. small-cap stocks outperformed large-cap stocks after lagging for the first half of the year, driven by a cooler inflation report and improved market sentiment.
The small cap segment can be extremely volatile in the short term, but they have the potential to offer very high returns over a long period. Small cap schemes are recommended only to aggressive investors with a high-risk appetite and long investment horizon, say, around seven to 10 years.