Good afternoon, everybody. This is Michael Cembalest with one of our July Eye on the Market webcasts. I know there's a lot going on this week, but for investors, there's something else happening that's important to keep track of, which is what's going on with small cap. And so we have a piece that we've been working on for a few weeks that's coming out this week called The Lion in Winter. I'll explain all about that.
Before I get into this small cap question, I just want to thank CrowdStrike for making the last 72 hours so interesting in terms of us trying to wrap this project up. I want to share a couple of quotes with you that I've got from FBI counterintelligence people and other people I spoke with who said, "CrowdStrike has done more to disrupt global business than all of the ransomware operators combined." That's obviously someone's personal opinion. And then another person referred to CrowdStrike having a severe failure of quality control.
What's interesting is that the CEO of CrowdStrike was the CTO, Chief Technology Officer, at McAfee in 2010 when these things can happen. Right? They published an update that mistakenly said that a legitimate Windows file was infected, and it paralyzed computers at hospitals and schools, and government agencies. And McAfee ended up losing 40% of its market cap that day. And they had to send 4,000 employees out to help clients recover.
I'm hoping that what comes out of this are some procedures where companies that are using these tools don't automatically absorb all the updates and test them first, and not just on the assumption that the company that did the update tested it. Also, it is interesting, when the government chided Microsoft last year for a cascade of security failures, CrowdStrike's CEO used that as an opportunity to bash Microsoft and say that there's a crisis of confidence among security and IT teams within the Microsoft security customer base. So we'll see what happens now.
OK. So here's this beautiful picture of a lion in winter. It's actually an amazing movie, if you haven't seen it, with Peter O'Toole. But lion and winter are used as a metaphor for small cap. I mean, most people don't think about small cap as a lion. But believe it or not, it used to be and was for 100 years.
We start out the piece with a chart showing that from 1930 to around 2010, small cap generally crushed large cap. This is looking at—we have a chart that looks at three-year rolling outperformance of small cap versus large cap. There were six distinct, long—meaning a decade or more—eras where small cap outperformed large cap. And so that's why this is the lion in winter, because it's been a long winter since small cap had this kind of outperformance. Certainly, on a sustained basis, it hasn't happened since before the financial crisis in 2009.
So we wanted to take a look at what's going on because small cap is now at its cheapest level in the 21st century. Now, to be clear, small cap is a—has trailed large cap, and so has non-U.S. stocks, and so value stocks. When you look at a chart on earnings growth over the last decade, large cap growth earnings have kind of crushed everything else, and with a remarkable lack of volatility. The amazing thing isn't so much that large cap growth earnings are higher than small cap and non-U.S., and value, and stuff like that. It's how resilient they've been during economic downturns.
And we have a chart in here that's kind of remarkable. You would not believe the earnings drawdown that took place in the Russell 2000 small cap universe compared to a very small one in large cap growth. So that's why people are paying those high multiples for large cap growth. But everything eventually has a price. Sometimes it's hard to anticipate how far the rubber band stretches.
After the soft June CPI report, we had the biggest one day reversal in 40 years for small cap, and defined as the one-day performance of small cap versus the Nasdaq. So on the day of the soft June CPI report, the Nasdaq underperformed small cap by almost 6%, which was by far the biggest number in 40 years. And then, if you look at the whole week, you get the same story.
So the purpose of this piece is, is this a trend or not? And so a table of contents—we try to cover a lot of ground here. Let's be clear about something. Small cap increasingly was not cheap just because people had a large cap growth fetish. There's a lot of data in here showing that the small cap universe has a lot of really marginal companies. So I'm going to walk through some of the charts that you could see in the piece that will help you understand this.
The first one is on free cash flow margin, where the large cap universe is crushing the small cap universe. And the small cap universe, we talk about both the S&P 600 and the Russell 2000. The S&P 600 has at least some criteria for being included, whereas the Russell 2000, if you have a pulse, you get included. And so portfolios that look like the Russell 2000 have, for many times over the last—for many periods over the last decade or so, have barely any free cash flow margin at all.
And similar story—if we look at the share of companies in the large cap universe that have negative earnings, it's around 40%. It used to be 25%. It's gone up to 40%, whereas in large cap, it's ranged anywhere from, let's say, 5 to 15%. So there's a lot of unprofitable companies. Some of them are probably smaller biotech and other healthcare.
Return on invested capital—large cap looks much better than small cap. Exposure to interest rates—the large cap stocks got the memo that during a decade of financial repression, you're supposed to extend the duration of your liabilities. Small cap—whether you look at the Russell 2000 or the S&P 600, they didn't. Still, only a little more than half the companies, about half the DOW outstanding in the small cap universe, is fixed. The rest is floating, whereas the floating component in the large cap S&P 500 universe is less than 10%.
So I don't know what screens they were looking at to go into this with so much floating rate debt. And because of that, if we look at debt to cash flow, obviously much higher for small cap companies compared to large cap, and then much worse returns. So cheap for a reason is how I've typically described small cap over the last 12 to 15 years because the companies were just so inferior in terms of their cash flow generation and their level of indebtedness. But as I mentioned earlier, everything has a price. So the question is, has the evaluation gap widened enough? Are you being paid for the risks in small caps?
I think we're getting closer. So let's take a look at what is driving the underperformance by sector and what—this chart, I think, is really interesting. My prior assumption is that small cap technology hasn't kept up with large cap but did OK. And it really hasn't. Over the last three, four years in particular, small cap tech stocks are flat at the same time that large cap tech has basically doubled.
This is really the biggest explanation or the most apparent one in terms of why small caps underperform. The technology companies in that index just don't do as well. And if we look across all sectors, it's not just technology where small cap underperforms large cap. It's also financials and healthcare, and consumer discretionary and consumer services, and energy and utilities. There's almost no sector where small cap has sustainably outperformed large cap. And so tech is the biggest piece of it, but it's not the only piece of it.
Now, so how cheap is small cap now? There's a lot of different ways to look at it. We look at it three different ways, and you come basically to the same conclusion, which is that small cap's cheaper than it's been at any time in the 21st century. You have to be very careful with valuation differences between two markets because the assumptions that are used to generate them could be different, like, for which indices you're using and which assumptions you're using.
The bottom line is pick an approach, stick to that approach, don't change the methodology, and then you can compare today's level to historical levels. But you can't kind of jump across metrics or indices. So, for instance, here the Russell 2000 we're looking at versus the S&P 500. I frankly don't understand how Bloomberg and the Russell 2000 are computing the PE ratio, given how many companies have no profits.
The PE ratio of a profitless company is either zero or infinite, like, you pick it. So I like to look at the S&P 600 better. Again, those multiples are 25% below large cap. That's the cheapest that it's been since 2001. And we also have a very messy chart, which is also helpful that there's this giant pump of all the different valuation metrics you could look at to compare the market pricing for small cap versus large cap—trailing PE, forward PE, cash flow, debt to cash flow, price to cash flow, price to book.
You kind of look at whatever you want, and they all pretty much have the same shape, which is they were really—small cap was really cheap around 25 years ago. It hit its peak expensiveness period in about 2012, 2013, and has been plunging ever since. And then, if we want to look at things on an earnings yield basis, we get a similar story. Earnings yield is simply the inverse of price to earnings. And it's useful with indices, where there's a lot of unprofitable companies with negative earnings.
And so not to get too caught up in the math and the methodology, the bottom line is no matter which metric you pick, you're getting the same story, which is small cap is as cheap as it's been since the year 2000. So that said, I just wanted to mention that as bad as small cap has done, it has still crushed international. Mean. International has really, really struggled. And as we saw earlier when we looked at a chart on earnings, the MSCI World ex-U.S.—I think I'm going to make everybody dizzy and go back to that chart for a minute. I want you to see this.
We have a chart in here that shows the MSCI World ex-U.S., both including and not including emerging markets. These earnings have barely gone anywhere since 2011. Outside the U.S. has been a earnings wasteland. And so that's why having such a big overweight to the U.S. has been so profitable. So anyway, I did think that was important to point out. So as bad as small cap has done versus large cap, it has outperformed emerging markets, and also Japan and Europe.
Now, sometimes people will say, well, is one of the reasons why small cap has struggled that there used to be a lot more companies that would go public as small cap that would be successful, grow into mid cap or large cap companies, but the small cap investors have reaped the benefits on the way up. Now that's not happening as much.
There is some evidence that that has happened. It's not just a kind of cocktail napkin theory. So we took all the tech IPOs since 2010, and from 2010 to around 2017, the market was dominated by companies that when they went public, were micro cap or small cap. And then a lot of these companies started to stay private longer, so that by the time they went public, they weren't small cap companies anywhere. They were mid cap or large cap.
And we have a chart here that shows that starting in 2018, the market shifted where 30% or less of the tech IPOs were still small cap. The rest were mid cap or large cap. So there is some truth to the notion that the companies that are staying private longer—and think the average life of a, of a tech IPO used to be maybe six or seven years, and now it's over 10. So there's some evidence that that's one of the things that's going on.
And the last question we sometimes get is, well, small cap has underperformed large cap. But if I pick a good manager, can I make enough money to offset the difference? And the answer is typically in the U.S., no. And typically outside the U.S., no. In emerging markets, probably.
So we have a table in here that—let me just use an example. Let's take a small cap core manager. Small cap, over the last three years, has underperformed large cap by 12 or 13%. The alpha, meaning the outperformance of small cap core managers, a median one is three-and-a-half. So you underperform large cap by 12% or 13%. You made back 3% or 4% with manager outperformance. Even a top-quartile manager might have only earned alpha of 6%, so clawing back like half the underperformance.
But the bottom line is small cap managers, unlike large cap, tend to have positive returns versus their benchmarks, but not by enough to erase the entire underperformance gap versus large cap stocks. So some good news and bad news there. Good news on small cap manager performance versus their benchmarks, but not big enough to make up the whole gap.
So anyway, that's the piece. Please take a look. I'm recording this on Sunday, which is the day before tomorrow's webcast we're going to be doing with Michael Morley, which you may already have seen. But if you haven't seen it, you can watch a replay. We're doing a webcast on the political implications of Biden's withdrawal with a constitutional law expert that we've worked with for the last few years. So anyway, thank you very much for listening, and talk to you again soon. Bye.
Since 2005, Michael has been the author of Eye on the Market, covering a wide range of topics across the markets, investments, economics, politics, energy, municipal finance and more.
This material is for information purposes only. The views, opinions, estimates and strategies expressed herein constitutes Michael Cembalest’s judgment based on current market conditions and are subject to change without notice, and may differ from those expressed by other areas of JPMorgan Chase & Co. (“JPM”). This information in no way constitutes J.P. Morgan Research and should not be treated as such. Any companies referenced are shown for illustrative purposes only, and are not intended as a recommendation or endorsement by J.P. Morgan in this context.
GENERAL RISKS & CONSIDERATIONS
Any views, strategies or products discussed in this material may not be appropriate for all individuals and are subject to risks. Investors may get back less than they invested, and past performance is not a reliable indicator of future results. Asset allocation/diversification does not guarantee a profit or protect against loss. Nothing in this material should be relied upon in isolation for the purpose of making an investment decision.
NON-RELIANCE
Certain information contained in this material is believed to be reliable; however, JPM does not represent or warrant its accuracy, reliability or completeness, or accept any liability for any loss or damage (whether direct or indirect) arising out of the use of all or any part of this material. No representation or warranty should be made with regard to any computations, graphs, tables, diagrams or commentary in this material, which are provided for illustration/ reference purposes only. Any projected results and risks are based solely on hypothetical examples cited, and actual results and risks will vary depending on specific circumstances. Forward-looking statements should not be considered as guarantees or predictions of future events. Nothing in this document shall be construed as giving rise to any duty of care owed to, or advisory relationship with, you or any third party. Nothing in this document shall be regarded as an offer, solicitation, recommendation or advice (whether financial, accounting, legal, tax or other) given by J.P. Morgan and/or its officers or employees,. J.P. Morgan and its affiliates and employees do not provide tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any financial transactions.
For J.P. Morgan Private Bank Clients:
ACCESSIBILITY
J.P. Morgan is committed to making our products and services accessible to meet the financial services needs of all our clients. Please direct any accessibility issues to the Private Bank Client Service Center at 1-866-265-1727
LEGAL ENTITY, BRAND & REGULATORY INFORMATION
In the United States, JPMorgan Chase Bank, N.A. and its affiliates (collectively “JPMCB”) offer investment products, which may include bank managed investment accounts and custody, as part of its trust and fiduciary services. Other investment products and services, such as brokerage and advisory accounts, are offered through J.P. Morgan Securities LLC (“JPMS”), a member of FINRA and SIPC. JPMCB and JPMS are affiliated companies under the common control of JPM.
In Germany, this material is issued by J.P. Morgan SE, with its registered office at Taunustor 1 (TaunusTurm), 60310 Frankfurt am Main, Germany, authorized by the Bundesanstalt für Finanzdienstleistungsaufsicht (BaFin) and jointly supervised by the BaFin, the German Central Bank (Deutsche Bundesbank) and the European Central Bank (ECB). In Luxembourg, this material is issued by J.P. Morgan SE – Luxembourg Branch, with registered office at European Bank and Business Centre, 6 route de Treves, L-2633, Senningerberg, Luxembourg, authorized by the Bundesanstalt für Finanzdienstleistungsaufsicht (BaFin) and jointly supervised by the BaFin, the German Central Bank (Deutsche Bundesbank) and the European Central Bank (ECB); J.P. Morgan SE – Luxembourg Branch is also supervised by the Commission de Surveillance du Secteur Financier (CSSF); registered under R.C.S Luxembourg B255938. In the United Kingdom, this material is issued by J.P. Morgan SE – London Branch, registered office at 25 Bank Street, Canary Wharf, London E14 5JP, authorized by the Bundesanstalt für Finanzdienstleistungsaufsicht (BaFin) and jointly supervised by the BaFin, the German Central Bank (Deutsche Bundesbank) and the European Central Bank (ECB); J.P. Morgan SE – London Branch is also supervised by the Financial Conduct Authority and Prudential Regulation Authority. In Spain, this material is distributed by J.P. Morgan SE, Sucursal en España, with registered office at Paseo de la Castellana, 31, 28046 Madrid, Spain, authorized by the Bundesanstalt für Finanzdienstleistungsaufsicht (BaFin) and jointly supervised by the BaFin, the German Central Bank (Deutsche Bundesbank) and the European Central Bank (ECB); J.P. Morgan SE, Sucursal en España is also supervised by the Spanish Securities Market Commission (CNMV); registered with Bank of Spain as a branch of J.P. Morgan SE under code 1567. In Italy, this material is distributed by J.P. Morgan SE – Milan Branch, with its registered office at Via Cordusio, n.3, Milan 20123, Italy, authorized by the Bundesanstalt für Finanzdienstleistungsaufsicht (BaFin) and jointly supervised by the BaFin, the German Central Bank (Deutsche Bundesbank) and the European Central Bank (ECB); J.P. Morgan SE – Milan Branch is also supervised by Bank of Italy and the Commissione Nazionale per le Società e la Borsa (CONSOB); registered with Bank of Italy as a branch of J.P. Morgan SE under code 8076; Milan Chamber of Commerce Registered Number: REA MI 2536325. In the Netherlands, this material is distributed by J.P. Morgan SE – Amsterdam Branch, with registered office at World Trade Centre, Tower B, Strawinskylaan 1135, 1077 XX, Amsterdam, The Netherlands, authorized by the Bundesanstalt für Finanzdienstleistungsaufsicht (BaFin) and jointly supervised by the BaFin, the German Central Bank (Deutsche Bundesbank) and the European Central Bank (ECB); J.P. Morgan SE – Amsterdam Branch is also supervised by De Nederlandsche Bank (DNB) and the Autoriteit Financiële Markten (AFM) in the Netherlands. Registered with the Kamer van Koophandel as a branch of J.P. Morgan SE under registration number 72610220. In Denmark, this material is distributed by J.P. Morgan SE – Copenhagen Branch, filial af J.P. Morgan SE, Tyskland, with registered office at Kalvebod Brygge 39-41, 1560 København V, Denmark, authorized by the Bundesanstalt für Finanzdienstleistungsaufsicht (BaFin) and jointly supervised by the BaFin, the German Central Bank (Deutsche Bundesbank) and the European Central Bank (ECB); J.P. Morgan SE – Copenhagen Branch, filial af J.P. Morgan SE, Tyskland is also supervised by Finanstilsynet (Danish FSA) and is registered with Finanstilsynet as a branch of J.P. Morgan SE under code 29010. In Sweden, this material is distributed by J.P. Morgan SE – Stockholm Bankfilial, with registered office at Hamngatan 15, Stockholm, 11147, Sweden, authorized by the Bundesanstalt für Finanzdienstleistungsaufsicht (BaFin) and jointly supervised by the BaFin, the German Central Bank (Deutsche Bundesbank) and the European Central Bank (ECB); J.P. Morgan SE – Stockholm Bankfilial is also supervised by Finansinspektionen (Swedish FSA); registered with Finansinspektionen as a branch of J.P. Morgan SE. In Belgium, this material is distributed by J.P. Morgan SE – Brussels Branch with registered office at 35 Boulevard du Régent, 1000, Brussels, Belgium, authorized by the Bundesanstalt für Finanzdienstleistungsaufsicht (BaFin) and jointly supervised by the BaFin, the German Central Bank (Deutsche Bundesbank) and the European Central Bank (ECB); J.P. Morgan SE Brussels Branch is also supervised by the National Bank of Belgium (NBB) and the Financial Services and Markets Authority (FSMA) in Belgium; registered with the NBB under registration number 0715.622.844. In Greece, this material is distributed by J.P. Morgan SE – Athens Branch, with its registered office at 3 Haritos Street, Athens, 10675, Greece, authorized by the Bundesanstalt für Finanzdienstleistungsaufsicht (BaFin) and jointly supervised by the BaFin, the German Central Bank (Deutsche Bundesbank) and the European Central Bank (ECB); J.P. Morgan SE – Athens Branch is also supervised by Bank of Greece; registered with Bank of Greece as a branch of J.P. Morgan SE under code 124; Athens Chamber of Commerce Registered Number 158683760001; VAT Number 99676577. In France, this material is distributed by J.P. Morgan SE – Paris Branch, with its registered office at 14, Place Vendôme 75001 Paris, France, authorized by the Bundesanstaltfür Finanzdienstleistungsaufsicht(BaFin) and jointly supervised by the BaFin, the German Central Bank (Deutsche Bundesbank) and the European Central Bank (ECB) under code 842 422 972; J.P. Morgan SE – Paris Branch is also supervised by the French banking authorities the Autorité de Contrôle Prudentiel et de Résolution (ACPR) and the Autorité des Marchés Financiers (AMF). In Switzerland, this material is distributed by J.P. Morgan (Suisse) SA, with registered address at rue du Rhône, 35, 1204, Geneva, Switzerland, which is authorised and supervised by the Swiss Financial Market Supervisory Authority (FINMA) as a bank and a securities dealer in Switzerland.
In Hong Kong, this material is distributed by JPMCB, Hong Kong branch. JPMCB, Hong Kong branch is regulated by the Hong Kong Monetary Authority and the Securities and Futures Commission of Hong Kong. In Hong Ko.ng, we will cease to use your personal data for our marketing purposes without charge if you so request. In Singapore, this material is distributed by JPMCB, Singapore branch. JPMCB, Singapore branch is regulated by the Monetary Authority of Singapore. Dealing and advisory services and discretionary investment management services are provided to you by JPMCB, Hong Kong/Singapore branch (as notified to you). Banking and custody services are provided to you by JPMCB Singapore Branch. The contents of this document have not been reviewed by any regulatory authority in Hong Kong, Singapore or any other jurisdictions. You are advised to exercise caution in relation to this document. If you are in any doubt about any of the contents of this document, you should obtain independent professional advice. For materials which constitute product advertisement under the Securities and Futures Act and the Financial Advisers Act, this advertisement has not been reviewed by the Monetary Authority of Singapore. JPMorgan Chase Bank, N.A., a national banking association chartered under the laws of the United States, and as a body corporate, its shareholder’s liability is limited.
With respect to countries in Latin America, the distribution of this material may be restricted in certain jurisdictions.
Issued in Australia by JPMorgan Chase Bank, N.A. (ABN 43 074 112 011/AFS Licence No: 238367) and J.P. Morgan Securities LLC (ARBN 109293610).
References to “J.P. Morgan” are to JPM, its subsidiaries and affiliates worldwide. “J.P. Morgan Private Bank” is the brand name for the private banking business conducted by JPM. This material is intended for your personal use and should not be circulated to or used by any other person, or duplicated for non-personal use, without our permission. If you have any questions or no longer wish to receive these communications, please contact your J.P. Morgan team.
© $$YEAR JPMorgan Chase & Co. All rights reserved.
J.P. Morgan’s website and/or mobile terms, privacy and security policies don’t apply to the site or app you're about to visit. Please review its terms, privacy and security policies to see how they apply to you. J.P. Morgan isn’t responsible for (and doesn’t provide) any products, services or content at this third-party site or app, except for products and services that explicitly carry the J.P. Morgan name.
LEARN MORE About Our Firm and Investment Professionals Through FINRA Brokercheck
To learn more about J.P. Morgan’s investment business, including our accounts, products and services, as well as our relationship with you, please review our J.P. Morgan Securities LLC Form CRS and Guide to Investment Services and Brokerage Products.
JPMorgan Chase Bank, N.A. and its affiliates (collectively "JPMCB") offer investment products, which may include bank-managed accounts and custody, as part of its trust and fiduciary services. Other investment products and services, such as brokerage and advisory accounts, are offered through J.P. Morgan Securities LLC ("JPMS"), a member of FINRA and SIPC. Insurance products are made available through Chase Insurance Agency, Inc. (CIA), a licensed insurance agency, doing business as Chase Insurance Agency Services, Inc. in Florida. JPMCB, JPMS and CIA are affiliated companies under the common control of JPMorgan Chase & Co. Products not available in all states.
Please read the Legal Disclaimer for key important J.P. Morgan Private Bank information in conjunction with these pages.
Bank deposit products, such as checking, savings and bank lending and related services are offered by JPMorgan Chase Bank, N.A. Member FDIC.
Not a commitment to lend. All extensions of credit are subject to credit approval.