Ever been driving down the highway at a respectable 10 mph over the posted speed limit only to have a car (maybe a Tesla) zip right by you? You suddenly find yourself processing a mix of emotions: anger, frustration… even a little bit of envy.
We get the sense that is how many small caps are feeling in 2020. The immediate impact of Covid-19 on global equities was a reactionary flood of capital into large-cap technology names – an investing safe space to ride out the uncertainty created by the pandemic. A recent Barron’s article noted that Alphabet, Amazon, Apple, Facebook and Microsoft have a combined valuation of roughly three times the market cap of the entire Russell 2000 Index.
A common question is: what is considered small cap these days? The widely accepted representation of small caps in the market is the aforementioned Russell 2000 Index, which was created in 1984 and is used as a benchmark for asset managers, ETFs and investment banks. The range of market capitalization as of the most recent reconstitution for this index is approximately $95 mn to $1.7 bn.
By contrast, the S&P 500 measures the stock performance of 500 large companies listed on stock exchanges in the US, and is one of the most commonly followed equity indices.
The gap is widening
Historically, the returns from the Russell 2000 and the S&P have maintained a relatively close correlation.
From its creation in 1984 until 2015, the Russell 2000 has generated an annualized return of 8.1 percent, compared with 8.4 percent for the S&P. Over that period the total return for both indices was well over 1000 percent. Not too shabby!
But over the last five years there has been a notable disparity between the performance of the two indices, and even the most skilled market analysts have struggled to attribute a particular reason. From 2015 through 2019, the Russell 2000 had an annualized return of 6.7 percent, while the S&P generated a 9.4 percent annualized return.
Covid-19 appears to have further widened this gap as the spread between the performance of large caps and small caps has never been greater. In 2020 the S&P has largely recovered from the impact of the pandemic, rising 4.6 percent at time of writing. Conversely, the Russell 2000 and small caps in general have declined nearly 7 percent for the year.
There has been a decided shift toward size amidst the uncertainty, and the pandemic may have accelerated the adoption of a new economy defined by contactless commerce, a greater dependency on remote access and more at-home entertainment options; these emerging societal norms are manifest in large-cap technology stocks.
The proliferation of ETFs has also influenced market dynamics by absorbing a larger percentage of the investing public’s dollars and mindshare. These ETFs, like mutual funds, have helped portion and package large securities into easily investable buckets that deliver varying rates of return. In addition, the significant growth rate of a handful of large-cap technology stocks (such as those mentioned above) has certainly had a disproportionate effect.
So what can small caps do?
The obvious but painful answer is there is no quick and easy single solution to narrow the gap in equity valuation. This is especially true at a time when we are faced with a multi-faceted investment universe against a backdrop of global uncertainty.
One thing of which we are certain, however, is that those that offer ‘guaranteed’ solutions to increase market capitalization should remain on the periphery of our industry, where they can do the least amount of damage. Instead, companies should focus on the following core tenets and activities that seem particularly applicable in an environment where small caps are struggling to gain traction.
Use analysis and data to your advantage
In communications, nothing beats fundamental analysis in delivering a clear and concise message to an audience. There are numerous options for providing data via charts, tables and visual aids that can help validate a company’s investment thesis. For example, rather than comparing the performance of your company’s stock with a broader market index, research how it stacks up against a smaller, but more relevant, basket of industry peers.
Support your supporters
In college, I took a job as a telemarketer. Each of us was given a list of 500 random phone numbers to sell the Lincoln Journal-Star, the largest newspaper in Lincoln, Nebraska. Not surprisingly, it was challenging work. One day, the manager handed me a list of people who were previous subscribers whose subscriptions had lapsed. Upon reaching out, I learned that in many cases those individuals were happy to renew, but they had either forgotten or had requested a lower price. Either way, it was significantly easier speaking to them than to cold-calling random parties.
This analogy seems appropriate in the current climate in terms of trying to engage with a new investing audience. Shareholders that currently own, or previously owned, the company’s stock do/did so for a reason. They are the easiest targets for investor outreach because they have already subscribed to your newspaper!
Use media in all forms – it’s there and it needs you
The gold standard for small-cap media used to be an interview on a large financial news network, such as CNBC, or perhaps an article highlighting a new corporate initiative in The Wall Street Journal. These are still very viable and worthwhile outlets to reach a large audience of potential investors.
Another avenue to consider is both growth and value investment-oriented newsletters and online media outlets, which have exploded in number and scope. As these platforms have proliferated, the ever-increasing need for content beyond Elon Musk’s latest tweet or Facebook’s newest acquisition creates a valuable, daily opportunity for small-cap stocks to reach a broad audience hungry for new and unique stories. IR pros can help their clients create and foster these media relationships by identifying the appropriate media outlets, understanding their needs and respecting the mission.
Does slow and steady win the race?
The lingering uncertainty of Covid-19 has widened the performance gap between small and large-cap securities, challenged traditional valuation metrics and caused us to rethink the veracity of the efficient marketplace.
The onus is on smaller securities to be proactive and transparent in their dealings with the investment community. ‘Slow and steady wins the race’ will work only if slow doesn’t mean stagnant, and steady represents consistency – not complacency – in communications and engagement.
The 65 mph middle-lane crowd may have its day yet again.
Adam Prior is senior vice president of The Equity Group. This article originally appeared on The Equity Group website here
