No. of Recommendations: 6
Excerpts from a research paper on a key driver of smallcap underperformance these last 15 years, and why it's not likely to get better - (via Meb Faber's IdeaFarm subscription service)
As shown in Exhibit 3, the majority of capital is raised at the upper end of the
market, allowing firms to invest in more established businesses. Larger funds, having raised substantial amounts of capital, can support bigger deals in the later-stage VC market. The average Series D round has grown from approximately $50 million in 2014 to nearly $200 million in 2024. This financing enables companies to undertake large-scale transformations that previously required an initial public offering (IPO). As a result, companies can fund growth, scale operations, and drive technological advancements without the immediate need to go public....
The number
of companies listed on U.S. stock exchanges has decreased substantially since its peak in 1996, as it nearly halved to less than 4,700 in 2022. At the same time, as shown in Exhibit 4, the number of U.S. PE-backed companies grew to over 11,000. There are several reasons for this decline, including a decrease in IPOs and an increase in merger and acquisition activity, as companies have opted to stay private for longer. Since 2000, the IPO market has not been as prosperous. The number of annual IPOs has fallen to an average of roughly 250, with the exception of an outlier year in 2021 when over 1,000 companies went public. Additionally, the average age of companies at IPO increased from about four years to twelve....
For U.S. equity markets, this trend has put pressure on the small-cap premium as the Russell 2000
underperformed the Russell 1000 in 10 of the last 11 calendar years. While prolonged periods of leadership in public markets are not unusual, small-cap underperformance has been historically notable amidst one of the longest large-cap cycles in history. The last small-cap cycle began after the Dot-Com Bubble but the composition of the public equity market has since evolved, particularly as the amount of capital invested in private equity has ballooned. This may impact the outlook for small-cap equities if a new cycle emerges.
Given the current period of underperformance, mean reversion suggests markets are poised for a smallcap revival as valuations for high-quality small-cap companies that grow at structurally high rates are more attractive than large-cap peers. This alone, however, will not be enough to drive a pronounced market shift. Small-cap earnings have been depressed and a reversal in this trend is a necessary catalyst for a meaningful change. Furthermore, the quality of the small-cap equity market has come into question with non-earners surpassing 40% of the Russell 2000. These companies are more commonly distressed or illiquid with lower average returns which may negatively impact relative performance.
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