August 29, 2023

Setting the stage for small caps

Guests: Matt McGeary, CFA, Portfolio Co-Manager at Eagle Asset Management, and Tim Miller, CFA, Portfolio Co-Manager at Scout Investments

In this episode of Markets in Focus

A turbulent 2022 for all categories of stocks and a long-term cycle of outperformance from large caps have caused many investors to lose confidence in small caps. Yet the long-term outlook for small caps could be bright, according to Matt McGeary, CFA, a manager of small- and mid-cap strategies at Eagle Asset Management, and Tim Miller, CFA, a manager of small-cap portfolios at Scout Investments. They believe that a number of trends, such as onshoring, rising M&A activity, and expanding AI capabilities, could all help propel long-term growth for small-cap companies.

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Matt Orton:
Heading into 2023, small caps just couldn't catch a break. After dramatically outperforming in late 2020 and early '21, performance down the market-cap spectrum has left a lot to be desired. In fact, last year the Russell 2000 had its worst nine-month start to a year on record.

This is Markets in Focus from Raymond James Investment Management. I'm your host, Matt Orton, and I invite you to join me and my colleagues as we discuss the latest trends and developments driving the markets. Visit us at for additional episodes and insights.

To be fair, 2022 was a brutal year across most asset classes. Worries about a hard landing were pretty pervasive, and we endured the most rapid tightening of monetary policy in over 40 years. So, I guess it's no surprise that investors just wanted to sit on the sidelines or lean into high-quality companies or dividend growth to protect against the violent swings of the market.

But with growth proving to be a bit more resilient than many of us may have anticipated, and with somewhat constructive price action down the market-cap spectrum at the start of 2023, I think it's time to really focus on the opportunity set across smaller companies. And to help engage in that discussion, I have two small-cap veterans joining us today to really dive into the case for small caps and how they're assessing potential investment themes.

We have Tim Miller, co-portfolio manager of Scout Investment Small Cap Strategies, as well as Matt McGeary, who's a portfolio co-manager of the Eagle Vermont Small and SMID Strategies here to help take on and lead this discussion. Tim and Matt, thank you for being here today.

Tim Miller:
Good morning.

Matt McGeary:
Good morning. Thanks, Matt.

Matt Orton:
Of course. There's still some disagreement in the market around small caps, and specifically whether it makes sense to be getting more optimistic on the asset class or whether it's just too early, given lingering concerns around the ultimate path of the economy. Matt, maybe you can start off by highlighting some of the reasons to be more optimistic on small caps right now.

Matt McGeary:
Sure, thanks Matt. I think there's a few things I could point out. First is valuation. Now, valuation is not a great short-term indicator or a short-term catalyst, but over the long term, if you have a longer-term view, obviously your entry point is important. Valuation for small caps continues to look fairly attractive. It's about 10% cheaper than its long-term average on a PE (price-to-earnings) basis from an absolute perspective, and about a 25% discount to large caps relative to the long-term average. I think from a valuation perspective, small caps look reasonably good. Even if you look at only profitable small-cap companies, they also look relatively cheap, relative to their large-cap peers. So, from a valuation perspective, I think it makes sense.

I also think you can think about the dominance of the FAANG-M (a group of the largest mega-cap technology companies) trade, if not being over, I think is certainly diminished with increased regulation, with geopolitical issues happening, and very simply them being so over-owned over the recent decade. I think from a small-cap perspective, even a little bit of flow coming out of the mega caps, looking for a new home potentially into small caps, can make a huge difference.

There's also an interesting fundamental. When you think about why large caps have done so much better, particularly in the last decade, there's a good fundamental reason. The large caps had better margins, better cash-flow dynamics than the small caps. So, it makes sense that capital flowed there. I do wonder, thinking about what's been happening in small caps, we're starting to hear a little bit more talk from companies about focusing more on profitability, getting to profitability sooner. There certainly seems to be less appetite currently for long duration, nonearning small caps. So, to the extent that starts to be more of the norm and be more prevalent in small caps, you could see the margin discrepancy between small and large caps tighten up a bit, which would be certainly helpful from a fundamental perspective.

And then just lastly, I think just historically if we look back at small caps, they tend to do better than large caps if we are in a higher inflationary environment that does sort of, at least historically, portend to higher nominal growth, which benefits small caps. Certainly, all the talk we've heard about nearshoring and onshoring with more focus on the domestic economy would be more beneficial to small caps relative to large.

And then just lastly, if you look at long-term cycles over the last 80 years or so, you tend to see these cycles 10 to 12 year cycles of small versus large, and large caps have done quite a bit better over the last 10 to 12 years, and perhaps we're ready for a new small-cap cycle. So, I think there's a lot of reasons to look to the asset class in the current market environment.

Matt Orton:
Yeah. And performance this year, I think, at least at the start of the year, certainly supports the point that you just made, Matt, because I think the Russell 2000 was up almost 8% through the end of February. So, maybe there's something there. But we still haven't seen that sort of big breakout like we had in November of 2020 after vaccine Monday (when the effectiveness of the first COVID-19 vaccine was announced) or really the clear sign of an upcycle. And lower quality, smaller companies have been leading the market higher out of the gates. Tim, I'd love to get your thoughts on what hurdles might currently be holding small caps back from that big breakout. And to that end, how would you say your investment approach navigates short-term periods when more speculative companies are in favor?

Tim Miller:
Yeah, thanks Matt. There are a number of different factors that seem to be standing in the way of a breakout right now. We've obviously been dealing with inflation in an uncertain economic environment, and businesses and consumers have to be careful to navigate all that noise. But front and center right now is this current banking crisis we've all been witnessing. It likely isn't nearly as significant and widespread as what we witnessed back in the Global Financial Crisis, but it is most certainly an overhang. On top of that, we've seen the consumer continuing to spend. But there's a little moderation in consumer credit card spending in February. That could indicate a little bit more caution there. Overall, the strong labor market really seems to have bolstered consumer confidence. But there's clearly some concern when you look at a recent pullback in retail foot traffic. That's falling back down to 2018 levels, and a lot of that traffic appears to have shifted to the discount stores.

And then on top of that, a lot of retailers are actually starting to talk about consumers trading down to lower price products, as well. So, bottom line is the consumer still seems pretty strong, but there's definitely a bit of caution emerging there. And then on the other side, businesses, they've seen a little pressure, as well. Corporate margins have declined pretty significantly from their peak about a year and a half ago. A lot of that seems attributable to rising labor costs and just overall tightness in the labor market. But we're still seeing higher supply chain costs, as well. A lot of the supply chain woes that companies were dealing with have been addressed and they've made adjustments for these, but the costs are still definitely there. And then we more recently have heard about higher inventory levels from a lot of our companies and their customers, and that seems to be leading to software demand at least in the near term.

Going back to the biggest issues, I mentioned the banking crisis. But there are really two others, as well. There's a risk of monetary policy action as the Fed considers further rate hikes. And then I think the specter of the debt-ceiling negotiation is really hanging over the market, as well. We're confident that the debt ceiling will ultimately get raised. But until that happens, I don't think the market's really going to be able to rally very much.

Matt Orton:
And similarly, Matt, maybe to bring you in, Tim talked about some of these issues we're facing between banking crisis, monetary policy. How does this sort of environment create opportunities for investments as an active manager and how do you not get whipsawed if you try to make adjustments to your portfolio in these sorts of roller-coaster market environments?

Matt McGeary:
Yeah. I think that Tim makes some good points, and I think that clearly the tide is going out, and we're about to see who's swimming naked and who's swimming with a suit on. And you can run down the path, Tim pointed out a lot of the concerns from a macro perspective. And clearly from an 80,000-foot view, I think the era of extraordinarily easy money policy is probably over, zero or negative rates and seemingly incessant cash payments from the federal government, QE (quantitative easing), you can run down the gamut. So for me, that period looks to be over. And you look at it from an inflation standpoint and pricing. Pricing is an issue that we have been focused on intently over the last few quarters.

And it does seem like the easy period of everyone getting (the) prices (they wanted) is behind us and we're hearing from our companies that pricing going forward is going to be more strategic, more targeted, which just says to us that it's not going to be as easy to get as it has been in the past. (With regard to the) cost of capital, Tim mentioned the banking crisis. I don't know what the full ramifications of this are going to be, but one clear ramification is going to be the cost of capital going up and a little bit more friction in the financial system, and that is going to be certainly a headwind.

So, from our perspective, I think it's a great time to be an active manager because you're going to see companies being able to differentiate themselves from others, management teams being able to differentiate themselves. And it should be clear to investors which are the better enterprises versus others. And I think hopefully (the market will) start rewarding those better businesses, and that's certainly what we look forward to.

And in terms of avoiding whipsaws, from our perspective, I think the most important thing is to maintain discipline to your philosophy and process. It's something we focus on a lot, particularly in these markets that are so volatile, it’s important to have a perspective, stick to your knitting and really maintain a long-term focus and be willing to go against the grain, be willing to be a bit contrarian. We talk about that more in recent years than we have in the past because you see these violent swings in the market, and I think you have to be willing to maintain your conviction, be willing to go against the grain. I think having a long-term perspective makes a big difference. It’s important to focus, as we do, on just the better businesses, and to focus on your investment thesis and not let yourself get overly influenced by the flavor of the month and current market and current news flow dynamics.

Matt Orton:
Absolutely. And so maybe now I want to focus and get a little bit more specific and talk about some key themes that are likely to impact small caps going forward. In building on this idea of change in the market, something that hasn't gotten a ton of attention is that M&A (mergers and acquisitions) activity actually appears to be picking up at the start of 2023, across a few different sectors, which is in pretty sharp contrast to last year. Larger companies are finding more attractive opportunities to enhance their own value propositions. Now, Matt, how do you think this dynamic bodes for small caps as we move further into 2023? And in your opinion, what criteria could lead the trend to continue?

Matt McGeary:
Yeah, I think M&A for us has been a focal point, and I think the activity level is going to increase, and I think that should be positive for small caps in general. And interestingly, a more specific skew to strategic buyers versus financial buyers, which is certainly good to see from our perspective, as well. I think it is going to continue. I think all the things we just talked about, like higher cost of capital and maybe a slowing economy, I think all those things are going to lead to companies that have the ability to fund their own growth.

Companies that have good balance sheets are going to look at this environment and try to consolidate their industries or increase their scale advantages. This is the time to do it when you get a slower economy, when there is less access to capital. Those companies that have those advantages should use that. And I think we're going to see more of that. I would be hopeful that we see more of it from the strategic buyer side, with companies building out their capabilities and recognizing the value of some of these really high-quality franchises, particularly on the small-cap side, that could be able to add to their businesses. So, we think it continues, and we think it's going to be a potentially big driver for small caps in the next 12 to 18 months.

Matt Orton:
Great. And, Tim, given your focus in the growth space, have you seen any particular sectors or industries where significant valuation resets have led to more M&A activity, and how does that factor into how you’re evaluating companies?

Tim Miller:
As the markets pulled back, we've seen a pretty significant revaluation take place, there's definitely been some pickup in M&A, particularly in those really high growth areas that have pulled back the most. There was a really interesting piece out from Furey Research Partners recently that had a couple of pretty interesting observations. First, the percentage of acquisitions in the Russell 2000 that came from tech and healthcare was the highest it's been since at least 1993, and it's a little bit more than one-third of all deals. And then second, the percentage of all acquisitions in the Russell 2000 that were made by financial buyers, and we're talking about the nonstrategic private-equity-type buyers, that's also the highest it's ever been in that time period. It's roughly half the deals. So that's a pretty interesting contrast to what Matt and his team have been seeing in their portfolio.

And that's typically what we're looking for, as well – the strategic buyers rather than the financials. But we'll take any sort of acquisition in our portfolio that might come along. We're happy to see those deals happen.

Matt Orton:
Well perfect. And I think this is an interesting theme to continue to follow as move into 2023. But to pivot a little bit and look into another theme that I think is worthwhile is global supply chains, and supply chains have struggled to stay on track in meeting the needs of companies, as well as the consumer, over the past few years. You can blame it on COVID-19, geopolitical tensions, but rhetoric around the potential for companies to reshore parts of their operations and supply chains has become a lot more prevalent. And you've already mentioned that a little bit in some of this dialogue here, and you're seeing some companies already making investments. Maybe that's early signs of traction. But, Matt and Tim, what parts of the market are you seeing the most potential for reshoring to gain traction? And, to that end, what opportunities does that afford you as investors amidst an evolving supply chain landscape?

Tim Miller:
There's been a lot of talk about reshoring and more broadly, just diversifying supply chains away from China. As we've seen in the Inflation Reduction Act that was passed last year, there's nearly $400 billion of funding for clean energy and tax credits for electric vehicles manufactured here in the U.S. So, we should expect to see a lot of development to build capacity around both those markets. And then you mentioned the CHIPS Act. That should drive the development of semiconductor fabs (fabricators) in the U.S., particularly for developing a lot of the high-end semiconductors used in aerospace and defense, where there are going to be national security implications.

One thing to keep in mind, through all this, is just the fact that supply chains, tend to be very well- established, and you can't just break away from the existing supply chain. It can take years for companies to move sources of supply, and I think we'll probably see a lot of just simply moving to new lower-cost countries like Vietnam instead of relatively high labor cost markets like the U.S. And another thing to consider is whether or not we have the capacity as a country here in the U.S. to actually build all the infrastructure required to reshore this manufacturing, if it does actually happen. These are massive projects we're talking about, and there really are a limited number of people and companies with the technical expertise to execute this over the next decade.

We're talking about data centers, semiconductor fabs, battery factories, pharmaceutical factories, these are all in line to be built, not to mention the trillion-dollar infrastructure bill (Infrastructure Investment and Jobs Act) that was passed back in 2021. So, this is all just an enormous undertaking. As far as opportunities for investors in the changing landscape, I think there are ways to capitalize on this just by finding the early movers in reshoring or even taking advantage of some of the short-term inefficiencies that some of these moves can cause. A lot of the time, the market will really punish companies for some of the short-term pain that's inflicted when they're making these moves. So, it can really be an opportunity for a more patient and longer-term focused investor to benefit.

Matt McGeary:
I think Tim is right. I think I would just add that clearly it's interesting that supply chains have improved for sure, but have not normalized and are not really anywhere close to normalization, which I think is interesting after all this time. And I do think Tim makes a good point about how established supply chains are and how difficult that is to change. And you're hearing more this term now they're using is sort of “friendshoring.” So, this idea that maybe we can't bring everything back here for all those reasons that Tim mentioned, but we're going to perhaps move more sourcing away from, obviously, China into more places that we think are a little bit more friendly to us, from a geopolitical perspective, and hopefully can be more stable through the cycles. I think that's very legitimate.

Another thing that we're seeing, interestingly from a few handful of companies, is a renewed interest in more vertical integration in their businesses, companies that have the capability to manufacture more components that they use in their end products. We're seeing a surprising amount of that. I'm not sure that's going to be that broad-based, but I think it's another way for companies to address this. And I agree with Tim on what the potential end markets are – semiconductors, infrastructure defense, and everything around sustainability and the energy transition. Small caps tend to be equipment suppliers, component suppliers. I think the opportunities are potentially enormous going forward.

Matt Orton:
And I like the word friendshoring. That's a new one for me. And speaking of friendshoring and maybe the drivers of that, it's hard to talk about supply chains without bringing China into the fold. And China's finally reopened after three years of enduring zero COVID. So, time's going to tell how this fully plays out. So far I think it's been stronger than many may have expected. And while small caps are generally more protected from some global economic drivers, how will China's reopening, do you think, impact the space? And are there specific sectors or industries which may be suited to benefit the most from the world's largest population coming back online for the first time in nearly three years?

Matt McGeary:
Obviously, it's a big issue, it's an enormous economy. And there are particularly some obvious beneficiaries in the technology space. Energy consumption is a big one. I think the Chinese consumer, coming back, the Chinese tourists traveling, shopping I think is a big issue particularly in Europe and even here in the States. So, I think it's a major issue. I do think it's going to be interesting to see, though, and this sort of falls out of the small-cap space, but I think looking at Chinese consumption patterns, and we recently saw this discussion around EVs (electric vehicles) and the more competition that they're getting from Chinese brands. And we're seeing that really across the consumer landscape. I think certainly the government would prefer, the Chinese government, that is, would prefer, more focus on Chinese brands being purchased by Chinese consumers. I think that's going to be an interesting dynamic and particularly for the large-cap guys, but to see how that bleeds through the entire economy could be an interesting dynamic to watch as we go forward.

Tim Miller:
I think as Chinese demand really starts to pick back up, a lot of the basic materials used in a lot of the consumer products – electronic materials, things like that – I think you'll start to see a tightening of demand for a lot of those sorts of items, which could have a kind of knock-on effect here in the U.S. That should shore up some of the basic materials and markets, as well. It's a massive economy and a massive consumer base, as well, so there can't help but be knock-on effects around the world.

Matt Orton:
Right. And I think to hit on one more theme now that is very important to small caps is biotechnology. And even though biotech has basically been halved over the past two and a half years from relative underperformance, it's still one of the largest industries in the small-cap space, particularly in small-cap growth and a key driver of performance. So, Tim, given your focus and growth, can biotech still be a major growth engine for small caps and how do you approach the space given the pitfalls such as low-quality companies that really are dependent on binary outcomes?

Tim Miller:
Yeah, we definitely think biotech can be a major growth engine for small caps. This is an industry that pretty consistently grows at a high single-digit rate year in and year out, and it's ripe with drug development and advancement. Obviously, the industry's taken a pretty significant hit in the market over the past couple of years, and these businesses have been revalued. Earlier, Matt mentioned the market having less appetite for these long-duration, nonearning type companies, but there's still ways to make money, and we can't just ignore biotech because, like you said, it's still a pretty big piece of our Russell 2000 Growth benchmark. It's a little bit more than 8% of our benchmark today, the Russell 2000 Growth, and it's been as high as 20% in recent years.

There are companies that already have a drug approved and are making money but still have a nice pipeline of products so they can continue rapid growth. And there are other businesses that may have a failed drug, but a really innovative drug development or drug delivery technology, and they can license that out to lots of other biotech drug developers. So then they're exposed to a basket of drug candidates rather than just a single drug. So, really there are a lot less risky ways to still participate in biotech growth than a lot of investors may think.

Matt Orton:
Perfect. And I know we're starting to run out of time, so I want to focus the last question and our final comments on some areas of the small cap market that you believe are still poised for growth even in a slower macro environment. So, are there any secular growth trends that can drive long-term performance in the small cap universe? I'll leave it pretty open-ended. So, Tim, maybe we'll start with you, and then I'll give the last word to Matt.

Tim Miller:
Yeah, thanks. This is probably going to sound a bit cliched, but we think artificial intelligence and machine learning are going to continue to be a massive driver to the market and there are really lots of ways to capture this in small cap. Obviously, ChatGPT has been a big story already this year. But in recent years, AI has been used by companies to manage customer interactions. Pharmaceutical companies use it to screen drug compounds. Banks and insurance companies are doing predictive analysis and risk management around catastrophic insurance events or banking default risks. So, as an investor, there are really a lot of ways we can ride the wave. You can invest in software companies that are capitalizing on developing AI tools. Semiconductor companies are developing chips to handle the huge computing and really power-hungry demands of AI servers. There are massive data centers being built and all sorts of infrastructure that's required around that. So, we're really excited about the opportunity and still just think there's a long runway in front of us for AI investment.

Matt McGeary:
Yeah, I'd agree with that, and I think from an infrastructure standpoint, I will say that when I started in this business in the mid '90s, there was a lot of discussion about needing to improve our infrastructure as a country. So, I take a little bit of the conversation around improving our infrastructure with a grain of salt from the powers that be. But there seems to be a more concerted effort, there seems to be more money flowing to it. This is a huge trend with potentially meaningful ramifications across a wide variety of end markets. Things like roads and bridges and airports and ports, 5G infrastructure, fiber buildouts. The electrical grid is a big one. If we have all of these goals to increase the electrification of our economy, the grid is not ready for that, and we've seen evidence of that in recent years. So, there's a lot of investment that needs to happen across a wide range of infrastructure projects.

I think we've talked about on this call, the energy transition, sustainability, there's a lot of constant news flow, people politicizing this issue unfortunately. But the reality is that the train has left the station on this, and spending is happening, consumers want it, the economics make sense. So, I think that's going to be a lasting trend.

Along with Tim's line on AI, I think automation and robotics is going to be a lasting trend as well. I just think the continuing need for efficiency and responding to demographic problems that we're having in this country in terms of enough workers, I think that's going to be a lasting theme. When I talk to my industrial companies, every single one of them, no matter what end market they compete in, talks about automation and robotics.

And along a similar line, is just software. It's been really popular to hate software the last year, and we've remained software bulls. I think none of this happens without really good software. So, I think that's going to be a particularly compelling trend. These are great businesses, and I think that the need has never been as great. And I think lastly, defense. I mean it's certainly an area where geopolitically, there's more focus being put on it now. I think it's going to be different kind of defense spending, probably more technical, more technology involved and more cybersecurity related. But nonetheless, I do think that that's going to be a compelling theme and one that's potentially good for small-cap companies.

Matt Orton:
Well, perfect. I think this is a great place to wrap up, and this has been a fantastic discussion. And so, Matt and Tim, I really appreciate your time, your insights on this really engaging discussion. Thank you very much to our listeners for consistently tuning in and until next time, take care.

Thanks for listening to Markets in Focus from Raymond James Investment Management. You can find additional episodes and market insights at You can also subscribe to our podcast on Apple Podcasts, Spotify, or your favorite podcast app. Until next time, I'm Matt Orton.


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FAANG-M is an acronym used in finance to describe a group of six prominent mega-cap technology and technology-enabled companies.

Vaccine Monday is a term used to describe Nov. 9, 2020, when the maker of the first vaccine for COVID-19 announced the results of a phase 3 study showing that its mRNA-based vaccine to be highly effective against the disease. The announcement led to a significant rise in equities.

The Inflation Reduction Act (IRA) is federal legislation passed in August 2022. It aims to help curb inflation by directing spending toward reducing carbon emissions and lowering health care costs, while also aiming to improve taxpayer compliance through increased funding for the Internal Revenue Service.

The CHIPS (Creating Helpful Incentives to Produce Semiconductors and Science) Act is federal legislation passed in 2022. It aims to increase investments in U.S. semiconductor manufacturing capacity, while also aiming to support the development leading-edge technologies, such as quantum computing, AI, clean energy, and nanotechnology, while also looking to create high-tech hubs that can foster a larger and more inclusive science, technology, engineering, and math (STEM) workforce.

The Infrastructure Investment and Jobs Act, passed by the U.S. Congress in November 2021, provides the funding for new initiatives to rebuild roads and bridges, improve public transit, replace lead pipes and address drinking water contamination, and to also expand access to high-speed internet.


The Russell 2000® Index measures the performance of the 2,000 smallest companies in the Russell 3000® Index, which represents approximately 7% of the total market capitalization of the Russell 3000® Index.

The Russell 2000® Growth Index measures the performance of the small-cap growth segment of the U.S. equity universe. It includes those Russell 2000 companies with higher price-to-book ratios and higher forecasted growth values.

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