Small caps gaining strength

Growing heft in M&A activity a key driver

We are still in a macro/fund-flow-driven environment, and while this continues to favour large cap stocks over small, it does introduce significant volatility into the more liquid parts of the small cap market. In the fourth quarter, we saw the Russell 2000 hit its 52-week low on Oct. 27, and recover to its 52-week high only 42 days later – the quickest turnaround in history. This was driven by large investors seeking easy liquidity and exposure to an asset initially looking to take risk off the table and then looking to add on risk with a normalizing interest rate environment.

We did see a strong rally in small caps into year end. We found this very interesting given the past few tax-loss selling seasons have been pretty hard on small-cap stocks. This year we did not see nearly as much volatility through the tax-loss selling season, and the performance into year-end is indicative of a strengthening small cap market.

Early innings or game over?

Over the past five-plus years, the common refrain you will have heard from this commentary is that small caps are trading at a discount to large caps, the inverse of what the long-term data show us. We’ve all been waiting patiently for the reversal to occur so we can bask in the delight of the small-cap performance, which history has shown to be very attractive. But…maybe it’s different this time. Markets change, and the market structure has changed. With the growth and dominance of passive strategies and the rise of HFTs, new forces control the market.

Index breadth performance

These market forces were in full effect for the first three quarters of the year as we saw seven stocks drive 85% of the gains in the S&P 500. This may have been the crescendo of a glorious run. In the fourth quarter we saw the breath of returns diversify as these seven companies only contributed 34% of the gains in the S&P 500 in the quarter. This trend appears to have continued into the new year.

Looking at macro fund flows, Canadian small cap has been a sector with negative flows for several years. With the exception of of 2021, the years 2020 and 2022 were substantive years for outflows in Canadian small cap funds, while the magnitude of outflows decreased in 2023 as we saw risk appetite increase into year end. Canadian small-cap flows remained negative overall in 2023 but all other small-cap flows were positive during the year. The Canadian market generally lags global and U.S. markets with respect to risk appetite and fund flows – we view this as a positive signal as we head into 2024.

Another key driver of returns both for the stock market, in particular the small-cap market, and something we’ve benefited from in our history, is corporate M&A. The chart below shows M&A of technology companies declined about 80% from the previous year. The acquisition of companies we did see enter into transactions tended to be opportunistic, “go private” transactions led by management teams due to the depressed valuations of the companies.

Two factors played into this lack of decreased M&A last year: 1) larger strategic companies were focused on improving their own operations, increasing their own free cash flow and were not looking externally for growth; and 2) rapidly rising interest rates and sudden valuation adjustments of public companies created an environment where not a lot of buyers and sellers agreed on price.

Share prices were depressed below where shareholders and boards valued the company. Moving into 2024, we have a stabilizing interest rate environment, and strategics have got their house in order, which we believe will lead to increased M&A by both private equity firms and strategic buyers.

2023 saw the slowest app IPO market in Canadian history. Canadian IPOs raised approximately $200 million last year, a decline of over 80% from the previous year and over 95% from 2021. The previous lowest year on record was 2016 when $600 million was raised in IPOs. We see this as a proxy for risk appetite, and this data point is very representative of how out of favour small-cap stocks and risk were in 2023.

With valuations improving and private companies coming to grips with lack of funding and declining valuations, we would expect to see more activity this year and in the years to come in the IPO market.

David Barr, CFA, is the CEO at PenderFund Capital Management and Portfolio Manager of several Pender funds, including Pender Small Cap Opportunities Fund. Sharon Wang contributed to this article. This article first appeared in the Pender commentaries. Used with permission.

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