Shifting Sands – Is It Time For Small Cap Value?

The investment landscape in the U.S. is showing signs of a significant shift: a rotation from large mega-cap tech stocks to small-cap and value stocks. Since the beginning of July, the Russell 2000 Value Index is up over 11%, while the S&P 500 Index has been flat and the Russell 1000 Growth is down -3%.

While it’s too early to declare a definitive trend, the current market dynamics suggest that this rotation could gain momentum, offering a timely opportunity for investors to reassess their portfolios.

Over the course of 2023 and first half of 2024, the divergence between the Russell 1000 Growth Index and the Russell 2000 Value Index has been driven by a massive investor demand for the “Magnificent 7” stocks and the booming AI sector. The result has been an increasingly crowded trade in a narrow group of increasingly expensive mega-cap growth stocks, which outperformed the rest of the equity market by a wide margin.

What Has Been the Catalyst for the Recent Strength in Small Cap Stocks?

The change in macro data is a big driver, as cooling inflation and a rise in unemployment result in a high likelihood for the Federal Reserve to begin cutting interest rates. This anticipated reduction in the cost of capital will have a more positive impact on small cap companies – given higher debt levels (particularly floating rate) vs. large caps. The market is now pricing in an almost 100% probability that the first rate cut will come at the September meeting.

The result has been a sizable unwind of the AI trades, with capital shifting to relatively neglected areas of the market such as healthcare and small/mid cap stocks. Time will tell if this will be a more durable broadening of market breadth and potential change in equity leadership.

Room to Run

Despite a strong July for down cap stocks, this segment of the market remains particularly attractive. As of quarter-end, the total market value of the Russell 2000 Value Index was $1.8 trillion; in contrast, the market capitalization for Nvidia was $3 trillion. While this may be a simplistic example, our view is that the market is overly discounting the collective earnings power of small caps.

The negative sentiment expressed towards small caps is further illustrated by market cap representation within the Russell 3000 Index. Currently, small caps comprise ~5% of the broader equity index – vs. their long-term average of 8.4%.  Simple mean reversion suggests that there is ample room for ongoing normalization of small cap equities moving forward.

Selectivity Remains Paramount

As investors in the small/smid asset classes, we are encouraged by the recent strength vs. what we view to be an extended trade in mega-cap growth stocks. Furthermore, we believe that the potential for material upside exists in small caps – given the low valuation/low expectation profile attached to many quality small cap companies at present.

With that said, rigorous underwriting and thoughtful security selection with small caps remain critical variables. Despite the increased likelihood of lower interest rates in the coming quarters, borrowing costs remain elevated vs. pre-COVID – favoring small cap businesses that possess strong balance sheets and demonstrated free cashflow.

We believe our Quality | Price | Discipline (QPD) approach is well-suited for the current market environment. Our team remains focused on finding high-quality companies that trade at reasonable valuations and offer the potential for asymmetric returns over a forward 1-2 year time horizon. Companies with high leverage, inconsistent margin/return profiles or outsized dependence on the debt/equity markets to sustain their business need not apply.

To learn more about Cambiar’s SMID and Small Cap solutions, please visit:

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