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Three Reasons to Consider a Long-Term Allocation to Small-Caps

April 2020 - 6 min read

The volatility driven by COVID-19 and the fall in oil prices has created much uncertainty—but it has also provided a potential opportunity to make long-term investments at attractive prices.

Small-cap equity markets have certainly experienced challenges related to the coronavirus fallout and significant decline in oil prices. And while risks remain, the recent market volatility has also resulted in a potential opportunity—particularly for long-term investments in good businesses with solid growth potential that have seen their share prices weighed down as a result of the pandemic.

In particular, we think there are three reasons small-cap equities are worth consideration for long-term investors.
 

1. Valuations Look Attractive Relative to History

European and International smaller companies fell by more than 20% in the first quarter, a steep drop reflective of the concern surrounding the spreading coronavirus. The bulk of this decline came in March as business confidence around the world faltered in response to the lockdown conditions being imposed across a number of economies. The severity and longevity of this crisis, and its ultimate impact on the global economy, are impossible to predict with any certainty—indeed, economists continue to debate over a muddled alphabet soup of potential economic recovery slopes. The effect on corporate earnings is equally as uncertain, although it seems very likely that a swathe of downgrades may be coming.

But the picture isn’t all negative. One result of the weaker performance and share price declines is that smaller companies have experienced an erosion of their price-earnings premium relative to larger companies. While small-cap valuations have not yet reached historic trough levels, they have become notably cheaper—and we believe they now look very attractive relative to history, and to larger companies. Going forward, with interest rates across developed markets generally at historic lows, and amid intensifying quantitative easing by central banks, equity earnings yields should remain supported—as long as earnings do not fall more precipitously than what markets are currently pricing in.

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