Higher interest rates have hampered the share price performance of growing smaller companies. But rates have not necessarily impacted operating performance of these companies. With inflation and rates falling, and corporate earnings growing, small cap valuations are attractive.
Interest rates and the cost of capital are key to the performance of growing smaller companies. Most investors buy smaller companies for growth, not for value. There are several reasons for this, including:
- The risks of buying a lower growth model at a cheap valuation are higher in smaller companies
- Balance sheets are more vulnerable
- Business models are more focused and less diversified
- Liquidity is a challenge, so investors may find selling the shares expensive or difficult to execute if bad news breaks
This means it is safer to focus on quality and growth, buying reliable business models with sustainable and repeatable earnings, and ultimately strong growth. The trade-off is that such companies command higher valuations. These factors are always important, but become more so when interest rates are high, and when the economic background deteriorates.
Interested in learning more?
Over the past three years, small cap has underperformed large cap. Their growth orientation, lower representation in the sectors that benefited from the changed environment (oil and banks), and a wider weakness in markets was a triple threat. But perhaps this perfect storm has blown over …
