The lethargy of large caps
As the economic slowdown takes hold, small-cap companies are often shunned by investors because they have less diversification in their revenue streams and thus suffer bigger drops in sales and profits during a slowdown. But they are also more flexible to adjust their cost base and preserve profit margins.
Small-cap stocks are considered to be more cyclical because of this increased sensitivity of revenues to the business cycle. Commonly, investors also think that the cyclicality of smaller companies is increased by increasing issues with financing during a downturn. Nicolas Crouzet and Neil Mehrotra put these theories to the test.
Using confidential census data in the US, they differentiated between the largest 1% of companies (i.e. companies with more than 2,500 employees) and the rest. Their sample spans all businesses in the US, listed and unlisted, but using the employee threshold, we can say that the top 1% of companies in the US by employees roughly coincides with large- and mid-cap stocks while the rest is more representative of small-cap stocks. Also, one important caveat to keep in mind is that the data only covers manufacturing firms in the US from 1977 to 2014. No tech companies or service companies.
They find that the top 1% of companies by size experienced a smaller drop in sales once a recession hits. A 1% drop in GDP led to a c2.5% drop in sales for companies in the top 1% but a 3.1% drop in sales for companies in the bottom 99%.
Impact of a 1% drop in GDP on US manufacturing businesses
Source: Crouzet and Mehrotra (2020). Note: Time = 0 marks the beginning of a recession.
The hit to the top line of a company’s income statement is thus bigger for smaller companies. But smaller companies have a distinct advantage over large caps when it comes to protecting their bottom line: They can cut costs much quicker than larger companies.
Looking at the path of inventories and fixed investments in the chart above, we can see that smaller companies reduce their inventory levels much faster than companies in the top 1% and then rebuild their inventories as the economy accelerates. Also, fixed investments are reduced pretty much immediately once a recession starts to reduce costs.
Large companies in the top 1% by size, on the other hand, are like large ships. You simply cannot turn them around as fast as you like. Investments remain in place and even rise after a recession has started and reducing inventories is such a slow process that inventories are falling when smaller companies are already ramping up their inventories at the end of a recession when demand increases.
On the other hand, the authors of the study reject the notion that a lack of access to financing becomes a hindrance for smaller companies during a recession. They find no difference between the top 1% and the bottom 99% in the evolution of bank debt to assets, short-term debt to assets or total debt to assets.
This can also explain why small-cap stocks tend to see their share prices drop more in the run-up and at the beginning of a recession. The greater cyclicality of sales is a disadvantage vs. larger peers. But once the recession is taking its course, small-cap companies start to outperform, particularly towards the end of a recession simply because they are able to react more quickly to cost pressures and take advantage of recovering demand. This is a big part of why small caps start to outperform large caps in a recession and immediately after one.
2022 was a year where large caps on outperformed small caps. As the recession unfolds in 2023, I think small caps will eventually be due for a comeback.