Small caps at historic valuation discount even after recent outperformance

The S&P Small Cap 600 index surged 11% in July, while the S&P 500 - dominated by mega-cap tech companies - increased by 1 %^[1]. As shown below, this 10% spread marked the largest monthly outperformance of small-caps versus large-caps in over two decades.

^{Source: Canopy Investors, Factset}

Such a significant move has understandably prompted speculation about an impending 'Great Rotation' from large-caps to small-caps. While the subsequent pullback in early August has tempered some of this enthusiasm, it doesn't negate the potential for longer-term shifts in market leadership.

At Canopy, we think it’s important to understand this result in a longer-term context.

Despite weak performance over the last decade, over the long term, U.S. small-caps have outperformed large-caps

The historical outperformance of small-caps versus large-caps has been well documented. The Fama and French dataset, spanning back to 1927, shows that the US small-cap factor delivered an average annual outperformance of +285 basis points^[2]. However, the past decade has diverged from this trend, with large-caps, led by US technology stocks, significantly outpacing small-caps. Consequently, despite their recent gains, small-caps still lag well behind over this period.

U.S. small-caps remain at a generational valuation discount to U.S. large-caps

The underperformance of small-caps in recent years has also outpaced the decline in their earnings estimates, resulting in a de-rating relative to large-caps. In fact, the spread between small-cap and large-cap P/E multiples has now widened to levels not seen since the dot-com bubble of the late 1990s.

Historically, such extreme valuation disparities often preceded periods of small-cap outperformance. As shown in the chart below, the excess return of small-caps versus large-caps over the subsequent three years tended to be largest when the relative valuation of small-caps was most depressed, as was similarly the case in the early 2000s.

^{Source: Canopy Investors, Factset}

With U.S. stocks representing ~70% of global small and mid-cap market cap, we think the U.S. experience is highly relevant to the global universe in which Canopy invests, and we believe there is further scope for small-caps to outperform from current levels moving forward.