Large-cap stocks have an advantage but fundamentals still matter

Jack Manley, Jack Manley

Jack Manley, executive director, is a global market strategist at J.P. Morgan Asset Management, responsible for delivering timely market and economic commentary to institutional and retail clients across the United States and Canada. In addition, he is a contributor to the J.P. Morgan Long-Term Capital Market Assumptions and has authored numerous papers on both global and domestic economies and capital markets. Manley is also a frequent guest on CNBC, Bloomberg, BNN and other financial news outlets and is often quoted in the financial press. He graduated from the University of Chicago with a Bachelor’s degree in History. He joined J.P. Morgan in 2013 as a member of the Asset Management Strategy & Business Development Team, where he worked on various strategic initiatives across the firm. He has been in his current role since 2016.

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Current economic conditions favour large-cap stocks, but company quality matters most regardless of size, says Jack Manley, vice-president and global market strategist with J.P. Morgan Asset Management.

“Whether it is the profitability story, the profit growth story, the interest-rate story, the debt-service story, the cost [of goods] story — almost all of these things favour large-cap stocks over mid- or small-cap stocks,” he said.

Nevertheless, he cautioned that economic factors affect every company differently, and investors should not neglect fundamental analysis.

“It’s not about buying the indexes. It’s about buying companies,” he said. “There will always be winners and losers. Being able to identify them, that’s what’s going to be critical to investing success, regardless of where you are on the cap spectrum.”

He said high-quality companies exist at all market caps.

“The market today is dealing with enormous numbers of dislocations,” he said. “This is a very strange-looking equity market, against a very interesting inflationary environment. Regardless of where you’re looking — large, mid or small [cap] — the emphasis has to be on security selection.”

Valuations

Manley said small caps tend to benefit more than large caps from two macro tailwinds: a strong U.S. economy and a strong U.S. dollar. As a result, any hiccups in U.S. economic strength hit small-cap companies harder.

“That could translate into a headwind for small-cap names because it’s going to make purchasing foreign goods more expensive and it may make domestic demand a little bit worse,” he said. “But that’s not something I’m particularly worried about right now.”

He said large-cap equities — particularly tech names — are showing valuation strength with a price-to-earnings ratio that is 127% more expensive than its 20-year average.

“All the momentum we’ve seen, thanks to this excitement around artificial intelligence and technology in general, is sort of a long-term secular trend that probably isn’t going away anytime soon,” he said. “It has allowed for multiples to bubble up higher in this one particular area.”

Meanwhile, valuations for small-cap stocks are slightly below their 20-year average. Among the reasons: commercial real estate has been under pressure since the work-from-home trend started in 2020, and small-cap financials lost value after the high-profile failure of several U.S. regional banks.

Performance expectations

Manley said 2024 is looking to be a good year for profit growth across the board.

Analysts are expecting earnings-per-share growth from the S&P 500 of 12% in 2024, following a relatively flat 2023. Mid-cap stocks are expected to post 8% year-over-year growth profits in 2024, following an 8% year-over-year growth in profits in 2023.

But the real winner could be smaller companies.

“Small caps are looking for a very significant reversal of fortune,” he said. “We actually saw small-cap earnings decline by 10% in 2023. We’re looking for them to grow about 23% in 2024.”

Profitability

“The elephant in the room when it comes to profitability is that 41% of the Russell 2000 — which is the U.S. small-cap equity index — is unprofitable,” he said. “Almost half of the index doesn’t make any money. And that is shocking.”

He believes that could be a side effect of the low-rate environment between the financial crisis and the start of the pandemic in 2020.

Companies went on a borrowing spree and “[threw] money at the wall to see what stuck, with no real repercussions if things didn’t work out so well,” Manley said.

Now many of those companies have “an interest rate-related hangover” where it’s a lot harder to generate a profit.

Mid-cap names, meanwhile, are faring better, with only 17.5% being unprofitable. And large-cap names are doing better still, with less than 8% of the S&P 500 companies failing to produce a profit.

Debt servicing

Manley believes debt servicing will continue to be the biggest challenge for small-cap companies.

He pointed out that roughly half of the outstanding debt held by S&P 500 companies matures after 2030, compared to only about 14% of outstanding debt in the Russell 2000.

“Everything else with the Russell 2000 matures before 2030,” he said. “What that means is that the maturity wall, so to speak, is a whole lot bigger and a whole lot closer for small-cap names, which makes them a lot more sensitive to refinancing risks.”

Furthermore, only about 6% of S&P 500 debt is floating rate, whereas nearly 40% of Russell 2000 debt is floating.

“Small-cap companies that have floating rate instruments have been sort of smacked across the face every single step along the way as the Federal Reserve has tightened screws and raised interest rates over the last few years,” he said. “This has been disproportionately punitive to those small-cap names.”

This article is part of the Soundbites program, sponsored by Canada Life. The article was written without sponsor input.