Yardeni Research Small Cap

[Georgeanna Abson]

PerspectivesWe closely follow the trends and opportunities presented by the market, investor preferences, regulations, and more, and offer our insights and explanations to help put it all in perspective.

The S&P 500 has been the talk of the investment world in recent years. Since the Global Financial Crisis (GFC) in 2008-2009, U.S. large-cap stocks have delivered strong annualized returns, outperforming all other equity classes Frontier models and setting a high bar for asset class performance. However, small-cap stocks are viable contenders for long-term investment due to their valuations.

The S&P 500 has been on an impressive run for over a decade, delivering a little over a 16% annualized return from the market bottom on March 9, 2009, through the end of 2023. The table below highlights its outperformance over all other major equity asset classes on both an absolute and relative basis.

Despite the historic performance of the S&P 500 over the past decade and a half, there seems to be a disconnect between past performance and forward-looking expectations. The reasoning? Valuations. Basing future return assumptions on past performance is generally not the best approach. Instead, valuations can be a more reliable predictor of future returns over long periods.

As shown below, the Forward Price/Earnings ratio of the S&P 500 is well above that of the S&P 600 Index (representing US Small Cap stocks), even after the small cap index significantly outperformed the S&P 500 in December. Coming out of the Global Financial Crisis in 2008, small cap stocks traded at a premium to S&P 500 based on the forward P/E ratios. This has changed substantially over the last decade plus, and small caps now trade at a significant discount. Based on the data shown, an investor is willing to pay almost 40% more for a dollar of earnings in the S&P 500 than for that same dollar of earnings in the S&P 600.

Another compelling argument in favor of future small-cap outperformance is their expected higher risk. Investment research generally asserts that small cap stocks have greater risk than large caps on average. Investors who support this assertion tend to agree that small-cap stocks are priced with the expectation of higher future returns to compensate investors for their higher expected risks. This has likely contributed to their significant long-term outperformance since the start of our longest strategy track record dating back to January 1999.

Investment decisions should be based on robust research and experience. Our process, refined through more than 20 years of managing money for our clients, focuses on what we believe to be the best predictors of future returns rather than relying on the simple assumption that what has outperformed in the recent past will continue to do so.

Our latest capital market assumptions call for attractive long-term returns for small-cap stocks, with expected outperformance relative to large caps both in the U.S. and internationally. However, this comes with more downside risk.

As always, we encourage investors to consult with their financial advisors and consider their risk tolerance and investment goals before making any investment decisions. We look forward to accompanying you on your investment journey, providing the expertise and insights you require to make informed decisions.

Exclusive reliance on the information herein is not advised. This information is not intended as a recommendation to invest in any particular asset class or strategy or as a promise of future performance. References to future returns are not promises or even estimates of actual returns a client portfolio may achieve. Assumptions, opinions, and estimates are provided for illustrative purposes only. They should not be relied upon as recommendations to buy or sell any securities, commodities, treasuries, or financial instruments of any kind. This material has been prepared for information purposes only and is not intended to provide, and should not be relied on for, accounting, legal, investment, or tax advice. Frontier does not directly use economic data as a part of its investment process.

Frontier provides model strategies to various investment advisory firms and does not manage those models on a discretionary basis. The performance and holdings of model strategies may vary from strategies managed by Frontier.

It is generally not possible to invest directly in an index. Exposure to any asset class or trading strategy or other category represented by an index is only available through third-party investable instruments (if any) based on that index.

The hypothetical illustration is provided for informational purposes only. The example given does not consider the impact of advisory fees and the reduction they will have on the value of a managed portfolio. The hypothetical performance does not include taxes or other known or unforeseen fees and expenses that may be incurred by an investor. No investment decision should be made based on the illustration.

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Investors, viewing the slowdown as temporary, have been willing to hold their noses and bid up share prices anyway. Plenty of Arizona-headquartered corporations certainly hope this "earnings recession" is drawing to a close, as many of these companies have struggled mightily in recent months.

The state's largest public corporations lost a cumulative $8 billion over the four most recent quarters, according to an annual midyear update by The Arizona Republic. That number was skewed by a numbing $12.6 billion loss logged by Freeport-McMoRan, the Phoenix copper-mining giant, as it battled high debt along with soft prices for metals and energy.

But few of the state's other bigger companies had especially memorable years, either, with only about half improving their profit picture over the four most recent quarters. Apollo Education Group, parent of the University of Phoenix, slipped into the loss column, while losses widened for Lifelock, the identity-theft defense company. Profits also eroded for truckers Knight Transportation and Swift Transportation and for homebuilders Meritage and Taylor Morrison.

Even Microchip Technology, one of Arizona's steadiest and most valuable companies, just posted its first quarterly loss in more than 25 years, largely reflecting restructuring and other charges tied to a recent acquisition.

Jeffrey Stafford, an analyst at Morningstar, expects Freeport-McMoRan will continue to struggle with low copper prices averaging around $2 a pound, which, in turn, reflect slow global economic growth. "We expect China's copper needs to fall in 2017 as real estate activity fades" and the country adapts more electric-power generation that uses less of the metal, Stafford wrote in a recent report.

On the other hand, some Arizona companies have enjoyed robust profit growth. Companies that boosted net income by 50 percent or more over the past four quarters include Store Capital, which owns a portfolio of commercial properties; solar-panel manufacturer First Solar; cable-TV operator Cable One; and Western Alliance Bancorp, the parent of Alliance Bank of Arizona and other financial institutions.

Our list of largest Arizona corporations includes only those entities with stock-market values of at least $100 million. Arizona counts about 170 smaller companies whose shares trade in public markets, according to researcher Morningstar. Most are chronically unprofitable entities that trade for pennies a share, or less.

Western Refining, which refines gasoline and operates a network of convenience stores and filling stations, was added to our top 40 list to reflect its main corporate presence in Tempe, though it retains its headquarters in El Paso. Another newcomer, TPI Composites, completed an initial public offering of stock in July. The Scottsdale company makes massive blades for wind-powered turbines.

Spirit Realty is one of 15 sizable Arizona companies paying dividends, providing investors moderately generous income in a yield-starved world. A few local entities have boosted dividends lately including Spirit Realty, portable-storage company Mobile Mini and Pinnacle West Capital, the parent of electric utility Arizona Public Service.

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