When do small caps outperform large caps?

We previously wrote about why large caps have outperformed small cap but in this article we discuss the environments where small-cap stocks can outperform large-cap stocks.

Early Stages of Economic Recovery

Small-cap stocks are often more sensitive to economic cycles and can benefit significantly when the economy starts to recover from a downturn. During this phase: Small-cap companies may experience faster revenue growth as economic activity picks up. They can quickly adapt to changing market conditions and capitalize on new opportunities. Investors may favour smaller companies with innovative products or services that gain traction as consumer and business confidence improves.

Sector Rotation and Market Cycles

Small-cap stocks may outperform large caps during periods of sector rotation or specific market cycles: When certain sectors or industries come into favour due to technological advancements, regulatory changes, or shifts in consumer preferences, small-cap stocks in those sectors can experience rapid growth. Small caps often have higher growth potential compared to large caps, especially in emerging industries or niche markets where innovation and disruption play a significant role.

Mergers and Acquisitions (M&A) Activity

Small-cap stocks can benefit from M&A activity, both as potential acquisition targets and as acquirers: During periods of economic expansion, larger companies may seek to expand their market presence or diversify through acquisitions of smaller, innovative firms. This M&A activity can lead to higher valuations and increased investor interest in small-cap stocks within specific sectors or industries.

Improving Market Liquidity and Investor Sentiment

As market liquidity improves and investor sentiment becomes more optimistic: Small-cap stocks, which are often less liquid and more volatile than large caps, can see increased trading volumes and price appreciation. Positive investor sentiment towards riskier assets may lead to a preference for small-cap stocks over larger, more stable companies.

Lower Interest Rates and Financing Costs

During periods of low interest rates and favourable financing conditions: Small-cap companies, particularly those with growth potential, may find it easier and cheaper to access capital for expansion and investment. This can fuel growth opportunities and investor confidence in the future prospects of small-cap stocks.

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Overall, while small-cap stocks can offer higher growth potential and opportunities for significant returns, they also come with higher risks and volatility. Investors interested in small-cap stocks should conduct thorough research, consider their risk tolerance, and diversify their portfolios accordingly.

Lauren Hua is a private client adviser at Fairmont Equities.

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Disclaimer: The information in this article is general advice only. Read our full disclaimer HERE.

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