The Capital Cycle Podcast - US Small Caps: Margin of Safety

Episode Date: May 30, 2025

The underperformance of smaller capitalisation US stocks leaves valuation multiples at historically high discounts to larger companies. Counter-intuitively, this may reverse in an economic downturn. Edward Chancellor talks to Tom Wharram, a US analyst at Marathon.For more information, or to access select articles from Marathon’s Global Investment Review publications which accompany this podcast series, please visit www.thecapitalcycle.co.uk Hosted on Acast. See acast.com/privacy for more information.

Hello, this is Edward Chancellor with another episode of the Capital Cycle podcast. I've got with me Tom Warham, who's a analyst covering the US with Marathon Asset Management. Welcome, Tom. Hello. Tom, we're going to talk about a piece you've written for the Global Investment Review about the relative attractiveness of US small-cap stocks. Over the past three years, the American stock market has become remarkably concentrated. in a handful of stocks to a degree never witnessed before or at least not witnessed since the

1930s. Periods of market concentration have in the past been accompanied by the underperformance of value stocks as measured price to book, but also in most instances by the underperformance of small-cap stocks. So can you briefly explain to listeners what's been going on in the US stock market? Yes, so 2022 we had a bare market in the US stock market. And since then, we've had two really exceptional years from the S&P 500. It was up cumulatively about 60% over 2023 and 2024. And as you mentioned in your introduction, that has really been driven by a small number of large technology companies, namely the Magnificent 7. And as the mega caps have taken a greater share of the market capitalisation, small caps. have underperformed. Yes, that's right. There are two indices you can look at to show that. One is the S&P 500 equal weight index, and that reduces the impact of the Magnificent 7 because it counts every stock equally. And that's returned about 30%, so about half the amount of the S&P 500 over

2023 and 2024. And then if we look at the S&P 600 index, that's the profitable US small cap index, that's returned even less. So that's returned 26% over 2023 and 2024. And that underperformance of US small caps has continued into this year. So up to the end of May this year, from the end of 2022 to May this year, small caps have cumulatively underperformed by 41 points compared to the S&P 500. Now, this is not just a question of changing valuations. The divergence in share price performance of the large and small caps has been matched by a divergence in the fundamentals in their earnings. Yes, that's right. So Raymond James have done some interesting work on this. If you take the total earnings for the S&P 500, they grew 2% in 2023 and 7% in 2024.

And once we exclude the Magnificent 7, so we now effectively have an index, which is the S&P 493, you find that earnings actually declined in 2023 by about 4% and they grew just 1% in 2024. So taking out those seven stocks, you reduce the earnings growth by about 600 basis points in both of those years. And you actually see an earnings decline over that period. And you say, but for the small caps, it's been even more pronounced.

Yeah, so much, much more stark for the small caps. So the S&P 600, earnings declined 11% in 2023 and 12% in 2024. So, you know, while the headline numbers that we've all seen for the US stock market have been very strong, at the small cap end of the market, it's been an earnings recession for the past two years. And you suggest that this is, to some extent, reflected by the lackluster performance of the economy, or at least how these small cap stocks are exposed to the US economy. Yeah, certainly parts of the US economy. The headline GDP growth figures in the US for the last two years have been pretty strong. been about 3%. But then when you look under the surface, you see that there have been lots of areas of weakness. So a good example would be the low-income consumer. If you look at dollar store

sales, more often visited by the low-end consumer, they were weak in 2024. If you look at things like credit card delinquencies or auto-loan delinquencies, they've been rising. And so that really indicates that the low-end US consumer hasn't been feeling that 3% headline GDP growth. And it's not just in consumer. If you look at on the industrial side, US manufacturing PMI's have been weak all the way through 2023 and 2024. And some of the industrial companies we've been speaking to have talked about an industrial recession and soft end markets in general. There is this parallel you can draw between a two-tier stock market and then also a two-tier economy. But you believe that this opening up the two-tier market in stock market leads provides an investment opportunity for marathon.

That's right. I should say that we're not investing with that sort of macro lens. What we're doing is looking for areas of the market where there is an interesting supply-driven investment opportunity. And that often takes us to niche corners of the market. And as a consequence, we end up overweight in small-cat companies. So would you like to give us a couple of examples? So I'll give you two examples. The first would be Invista Holdings. They're one of the major dental product manufacturers. They were spun out of Danaher in 2019. Dental is a growing category and Invisda has strong market positions. They do things like implants, orthodontics, consumables, and long term, there is significant room for margin expansion. But what we've seen in the past few years is sales and margins being weak, and that gave us the opportunity to invest. A second example would be Open Lane.

They're the market leader for online auction of off-lease vehicles. They're also one of the two major players in the online dealer-to-dealer, automotive transaction market. And what we've seen over the past few years has been off-lease auction volumes have been depressed because you had fewer cars built during the pandemic. That meant fewer leases. And that now means fewer vehicles coming off-lease today. And then on top of that, you have the leases that are ending at the moment,

tend to have a positive equity because used car prices have gone up so much. And that means that the lessor, the consumer, is choosing to purchase the car themselves rather than returning them to be auctions. So you've got this temporary earnings depression, which in the long run will normalise, and then on top of that you have the long-term shift towards the online channel. And these things aren't being recognised by the market.

So, Tom, people think about small caps and arguments to avoid them. They talk about macroeconomic risks, the greatest susceptibility of small-cap stocks to economic downturns. I think famously in the Great Depression, small-capped stocks massively underperformed. But you take a slight different view. That's true. And first thing I would say is I'm not making a call on the direction of the

US economy with this. You're right. The conventional view is that small caps would underperform in a recession, but that's not always true. And in 1998 and 1999, we saw the small-cap index underperform the S&P 500 by 45 percentage points. And that's pretty similar to the 41 we've seen in the last few years, and then 2000 and 2001, the small cap index outperformed with a recession bang in the middle of that, and actually small caps kept on outperforming right up to the financial crisis. So there are many ways in which the current environment is different from the dot-com era that period when small-cap stocks and value stocks were extremely cheap. But the valuation discrepancy to your mind is quite similar to how it was back in the dot-com bubble.

Yeah, absolutely. So if we look top down, the valuation picture of small-cap stocks versus large-caps is very similar to what we saw in the dot-com era. As I've said, we've had this 41 points of underperformance in the past few years, and that leaves the P-E ratio of the S&P 500 at a 40% premium to the S&P 600, and that's the highest we've seen since the dot-com era. So the S&P 500 is at 21 times PE, which is a 20% premium to the 30 year history. And the S&P 600 is at 15 times PE, which is a 13% discount to its 30 year history.

And in your piece, you have a chart showing the relative price earnings ratio of the S&P 500 to the S&P 600. And what we see is that in the dot-com era, the large caps were trading at a price to earnings premium, one and a half times, which is a bit higher than it is today, but not much higher. But we also see for a prolonged period after the global financial crisis, I think it actually precedes the global financial crisis from 2007 through to the end of the last decade, the small caps were actually trading at an earnings premium to the large caps. Yes, that's right. And this is even more stark, if you look on the price-to-sales basis.

So you have the S&P 600 trading at about one-time sales. So that's exactly in line with the 30-year history. And then the S&P 500 is trading at three-time sales, so three times as expensive. And that's an almost 70% premium compared with the 30-year average. So how much should one read into these wide valuation spreads between the large caps and the small caps? I think we do need to be a little bit careful. And I think particularly on price to sales, where at least some of the premium of the S&P 500 versus history may be justified by a structurally higher margin technology sector making up more of

the index. You've also got the fact that small caps are riskier than large caps, they have lower return on capital, and they have higher leverage. But I think even with those caveats, I think the data is still compelling that small caps are undervalued compared to large caps. I should say that if one looks at what the well-known quant investors in the US a writing about small caps, research affiliates, company run by Rob Arnott, AQR run by Clivaznes and GMO, My Old Shop. They are all reiterating the view that small caps look attractive. For instance, research affiliates put out a paper quite recently with the expectation that US small caps should outperform the broader market by 4% a year over the long term. But Marathon's not a quant investment firm, and you're not using the relative attractiveness of small caps as an example to sort of tilt the portfolio to small caps.

Marathon has other factors to consider. Yeah, I think that's absolutely right. We are not making investment decisions solely based on a factor or macro view about small cap versus large cap valuations. We want to invest in well-managed businesses with an attractive capital cycle investment case. but that often means we end up being overweight small companies. I think, you know, the way I think about it is, if you were to ask us, what conditions would you want to see for a strategy that is overweight small caps?

I think we'd sketch out a scenario pretty similar to the one we have today. So thank you, Tom. And as a last thought, this is not a phenomenon confined to the US, that small caps are not just attractive to the US. Your colleague, Justin Hill, wrote about the attractive, in small caps in the EFA basket, the developed markets outside of the US. And he wrote about that in November 23, so roughly 18 months ago, where he pointed out that the small caps had underperformed in the period up to that

period by, I think, around 25%. And that the stocks, the small cap stocks within the EFA universe, were at a 40% discount on price to sales. So both within the US, it would appear, but more broadly, small caps look to be a relatively attractive place to be stock picking. And to your point about marathon looking for stocks that in a good place in the capital cycle, I think what should help you pick up at least is the risk that would come from leverage or deteriorating profitability, which one can see in the United States.

but this is where I think stop picking skills come in or fundamental investment skills come in more useful than just owning an indiscriminate basket of small cap stocks. Yes, absolutely. So thank you very much and look forward to speaking to you again. Thank you very much. Nice to speak to you. Thank you for your time today. I hope you will listen to the next edition of the capital cycle.

This communication is provided for information purposes only. Please refer to Marathon's website and the Global Investment Reviews for further information, including important disclosures.