Why Small Caps Are Extremely Attractive Today

On this episode of The Long View, Wasatch Global Investors CEO JB Taylor discusses why small caps have underperformed, where his team finds fruitful opportunities outside of the United States, and how technology transforms every company in one way or another.

Here are a few excerpts from Taylor’s conversation with Morningstar’s Christine Benz and Dan Lefkovitz.

What Is the Key to Underperformance?

Christine Benz: Small caps have meaningfully underperformed in the US for many years now. Can you talk about what you think is the key to the underperformance?

JB Taylor: The last 10 years, you’ve had this unbelievable run in the big-cap stocks, but specifically the mega-cap stocks. And everyone is talking about the “Magnificent Seven”—Apple AAPL, Microsoft MSFT, Alphabet GOOGL, Meta META, Amazon.com AMZN, Nvidia NVDA, and Tesla TSLA. These are phenomenal companies, and all the momentum in the market has gravitated toward these companies, and for good reason. They’re great companies with great competitive moats. If you look back over the last 10 years, the combination of cloud computing, a smartphone in every hand, and now the advent of AI, there are a lot of reasons that these companies have been able to grow to enormous scale and then enjoy the benefits of that scale.

But if you look at the history of large cap versus small cap, there do tend to be cycles. If you go back over the last 100 years, the average performance period of large beating small or small beating large is about 10 years on average. The longest period of large-cap outperformance was 14 years, and it was that period leading right up into the internet bubble and burst, which was followed by 10 years of small-cap outperformance. And now we’re in year 13 of large-cap outperformance. So, from that standpoint, just from timing, small caps certainly seem interesting that we’ve run a long time now with the large-cap companies doing quite well.

The other thing that’s interesting about large cap versus small cap right now is that from a relative valuation standpoint, small caps are extremely attractive. We haven’t seen small caps broadly this cheap versus large caps at any point in the last 25 years. And again, it’s going back to right before the dot-com bust. The small-cap index is trading at about 13 times earnings today. And the large-cap index in total is trading at about 20 times earnings. But if you take that Magnificent Seven, they’re trading more like 40 times earnings. So, a huge valuation discount.

And then the other interesting thing about this large-versus-small phenomenon is that you’ve got about 30% of the S&P 500 and Russell 1000 in these seven stocks. And that’s an enormous concentration. Historically, the top 10 names of the Russell 1000 in any given year are not a great place to invest going forward over the next five years. The success that gets companies to the top of that index, it’s hard to repeat. But the exception has been the last five years, you’ve had momentum carry year to year in the top weights of the Russell 1000. So again, this idea of a lot of momentum crowding into the top of these stocks. The last time that you had this crowding and that momentum carrying in the top 10 stocks of the big indexes was again, going back to that runup up to the dot-com bubble and burst, and the period after that was just a phenomenal time to be investing in small-cap stocks.

Going Global for Opportunity

Dan Lefkovitz: Curious if there are certain markets that you found especially rich in opportunity or markets that you found particularly challenging?

Taylor: I would definitely highlight India. We have a phenomenal India-focused mutual fund run by Ajay Krishnan. It’s done great because we’ve been able to invest—India was one of the first companies that we really dove into when we started our ex-US efforts and it was from the bottom up. It’s not because we had some big macro take on India, which many people have really constructive views on. It’s more about the fact that when we were going through our financial resumes of companies, we were just finding tons and tons of companies with 15% to 20% growth, not very expensive, good margins, good returns on capital. Capital has never been easy in India. So, those companies that can generate good returns on capital are doing something special and truly figured out cost and efficiencies and great management.

I’ll contrast that with China. China is a really difficult market. A huge important country and a huge important market, but the return on capital discipline there has never been quite the same. Money has been cheap through certain times, and it’s definitely been a market of growth at all costs as opposed to generating great efficient returns. And so, in China, you get more of those fake growth companies that are showing three or four years of great top-line growth, but it doesn’t have a strong underpinning of cash flow or balance sheet support. So, they’re blowing out their balance sheets to get it. They’re making tons of acquisitions. They’re just upping the risk profile of the company, and then all of a sudden you have a company that doesn’t grow and doesn’t have margins, and that can be very difficult. So, we’ve had to be more careful and picky in China, whereas a place like India has been fruitful.

How Technology Plays a Role Everywhere

Benz: You’ve said that every company is a technology company. What do you mean by that?

Taylor: I just think in the last 15, 20 years, software has become so easy to deploy with the cloud, easy to update, easy to change, easy to apply, easier to install, that companies have to be adopting technology. It doesn’t matter what industry you’re in, but if you’re not using the best technology for your company, you’re going to miss out. And so, we think of every company in terms of how they apply tech to gain competitive advantages and do better than their competitors.

We love businesses that are sleepy, a little bit under the radar, not things that everyone thinks of as being a growth business. One of the best investments we’ve ever had is a company called Copart CPRT. They pick up salvaged vehicles on behalf of insurance companies and then auction them off to buyers who take those cars apart for the parts or they rebuild the cars to make them what they call straight cars, drivable cars again with salvage titles. And this is a company we’ve owned for 20-plus years. It’s been a phenomenal winner in a business of junkyards. Not many people think of it as being a growthy business, but they very early saw the internet as a way to change the business. Previously, all these auctions were done at a local level where buyers would come and bid on cars, just like you’d see at an auction with an auctioneer and all that. And they were the first to put all these auctions up online, which now seems like an old idea, but at that time, it was revolutionary, and it changed the business forever, and mom-and-pop junkyards that were in the same business couldn’t compete. And so, they rolled up that industry. And now if you wreck your car, if you salvage it, and the insurance company calls it a totaled car, there’s about a 50% chance it’s Copart that comes and picks up that car and takes it to one of their facilities and then it auctions it off to the highest bidder. And they just make a really nice fee every time they do that. And so that’s an example of a company applying technology that’s not a tech company, but it absolutely transformed the business and transformed the industry.