Small Caps Offer Opportunities, Especially When Rates are Rising

Chris Tessin of Acuitas Investments recently authored a piece for the InvestmentNews that outlined the historical pattern of micro-cap and small cap outperformance during periods of rising interest rates.

Tessin notes that small firms have now lagged large cap names on a 1, 3, 5 and 10-year basis, and that relative underperformance is now producing an investment “opportunity”. According to Tessin, smaller firms have a history of outperforming during periods of increasing interest rates, and the magnitude of outperformance is “greater than the long-term relative return premium normally associated with investing in these asset classes.”

There are two reasons why small companies tend to outperform during these periods. First is that larger companies tend to borrow more during periods of low or falling rates. As rates start to increase, smaller firms, which on average have borrowed less, are less effected by the increasing borrowing costs. In addition, raising rates often coincide with higher growth, which are periods that have more economic benefits for smaller firms.

Tessin cites some compelling historical data to support this thesis. For instance, since 1963 there  have been 10 periods in which the 10-Year U.S. Treasury was rising and 70% of the time, small caps beat large caps. “The average annual return premium for small caps over large caps during the 10 periods of rising rates was 7.60%, while the annualized relative return of small caps over large caps from 1963 to 2014 was 2.55%,” he writes.

Tessin concludes, “given valuations and the historic outperformance of microcaps and small caps in periods of rising rates, this end of the market is worth a close look.”