Can Small Cap Stocks Weather the Storm?
With recession concerns intensifying in the wake of the COVID-19 pandemic, investors may be wondering whether small cap stocks are poised to struggle. Are small companies more vulnerable now than they have been during other periods of economic distress? And what are the implications for the size premium?
Even if the economy has entered a recession, it does not necessarily follow that small cap stocks should under perform. Why? Current market prices already reflect expectations about future cash flows, including any impact of an economic downturn. So even if the effects of a recession are more heavily borne by smaller companies, small cap stocks can still deliver higher expected returns.
Turning to the data, the first question we want to answer is whether small cap companies were displaying any unusual trends leading into the current crisis. If the financial characteristics of small cap firms in recent years have been in line with long-term averages, we can use historical data to help us understand the potential range of outcomes going forward.
One common measure of a company’s relative strength is its leverage, or the relative value of its debt. A company whose financial standing has deteriorated during an economic downturn may experience rising leverage that is less sustainable over a long period. When measured using total debt scaled by total assets (Panel A of Exhibit 1), aggregate leverage rates for US small caps have actually been similar to those for US large caps, and relatively stable through time. Another conventional measure of leverage is interest expense scaled by EBITDA, a way to assess companies’ ability to pay their debt through earnings. As illustrated in Panel B of Exhibit 1, US small caps appear more highly levered than US large caps, but their leverage has remained in line with historical trends.
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Robert J. Pyle, CFP®, CFA is president of Diversified Asset Management, Inc. (DAMI). DAMI is licensed as an investment adviser with the State of Colorado Division of Securities, and its investment advisory representatives are licensed by the State of Colorado. DAMI will only transact business in other states to the extent DAMI has made the requisite notice filings or obtained the necessary licensing in such state. No follow up or individualized responses to persons in other jurisdictions that involve either rendering or attempting to render personalized investment advice for compensation will be made absent compliance with applicable legal requirements, or an applicable exemption or exclusion. It does not constitute investment or tax advice. To contact Robert, call 303-440-2906 or e-mail info@diversifiedassetmanagement.com.
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