216-292-2950 [email protected]

Brandon Hemmelgarn

Co-Chief Investment Officer

After a robust start to the year for most stock market participants, with the S&P 500 increasing 7.5% in the first quarter, many investors may be questioning their allocations to small cap stocks which rose just 2.7% in the quarter. For investors in this segment of the market, the frustrating trend is not just a 2023 phenomenon, as small cap stocks also lagged in 2022 and 2021.

In fact, over the last five years through 12/31/2022, small cap stocks have lagged by over 5% per year, with an annual return of 4.1% relative to 9.4% per year for the S&P 500. With recent news headlines highlighting bank failures and elevated recession risks, it can be hard to envision the trend changing anytime soon as larger companies tend to offer lower volatility and more stable business models compared to their smaller peers.

However, for those looking beyond the uncertainty of the next few months of 2023, we may be approaching a historically rare opportunity for small cap stocks to generate meaningful outperformance for investors with longer time horizons over the next 3-5 years. Given the difficulty to perfectly time any investment, we think it makes sense for investors to begin increasing their allocations to small cap stocks, and plan to periodically do so over the next 6-12 months to position themselves ahead of several multi-year tailwinds:


The cyclical nature of the relative performance for small vs. large stocks

  1. Small caps historically outperform following bear market drawdowns in stocks
  2. Attractive valuations for small caps relative to large caps
  3. Slowing inflation is a tailwind for stocks broadly, and particularly small caps

 Let’s dig into each of these with a few charts.

The cyclical nature of the relative performance for small vs. large stocks

Historically, the stock market has gone through multi-year cycles in terms of the relative outperformance of small caps or large caps (albeit with shorter-term performance cycles month-to-month), as shown in Chart 1.

 

Chart 1: Relative Performance of Small Cap Index vs. S&P 500 (1988 – Present), Source: Intrinsic Research

Over longer time periods, the performance of both small caps and large caps tends to converge at an annual return rate of ~10% (matching the long-term annual growth in earnings plus capital returned to shareholders). Extreme outperformance of either large caps or small caps tends to reverse over time due to the general efficiency of markets, and consistent outperformance will be arbitraged away and disappear. Academic research has historically made an even stronger case for small caps, suggesting that small cap stocks tend to outperform over time due to the riskier nature of such stocks, and investors are compensated with higher returns for the additional risk. While it is difficult to predict the exact timing of when the performance cycle will shift back in favor of small cap stocks, Chart 1 suggests that the recent large cap outperformance is approaching extreme levels and is less likely to continue.

Small caps historically outperform following bear market drawdowns in stocks

One other observation from Chart 1 is that small caps tend to outperform following recessionary bear markets—20%+ declines in stocks that coincide with an economic recession (shaded regions in the chart). In each of those periods over the last 35 years, small cap stocks outperformed large cap stocks as stocks broadly rebounded from their lows and the economy recovered. Conceptually, the outperformance makes sense as small caps tend to be more volatile and sensitive to the economic cycle.

Many economists and forecasters anticipate a recession in 2023 or 2024, and the stock market has done a great deal to price in such a scenario for the economy with the S&P 500 down over 25% at the October 2022 low (~14% below all-time highs currently), and Small Caps down over 30% at the October 2022 low (~26% below all-time highs currently). While there may be some additional downside if a recession occurs, economic weakness and lower profits already seem to be reflected in the prices of small cap stocks so the incremental downside may be more limited than heading into other recessionary periods. In a “soft landing” scenario in which a formal recession is avoided, the stock market may have already hit the low point of the cycle, but we would anticipate a similar move higher for small cap stocks as earnings and economic data reaccelerates. In either a soft landing or a recession, history indicates that small caps will likely outperform large caps in the first few years of the new bull market.

Attractive valuations for small caps relative to large caps

Coinciding with the underperformance of small caps relative to large caps over the last five years, a large valuation multiple discount has developed for small cap stocks. Chart 2 shows the Price / 12-month Forward Expected Earnings (Forward P/E) ratios for large caps (S&P 500 index), mid caps (S&P 400), and small caps (S&P 600). Small and mid-cap stocks currently trade at ~13x Forward P/E, compared to a relatively more expensive 18x Forward P/E for large cap stocks. 13x Forward P/E for small and mid caps is comparable to the low double digit multiples those stocks troughed at during the 2008-2009 and 2020 bear markets, which were followed by new bull markets with historically strong stock returns and meaningful small cap outperformance in the subsequent years. Furthermore, the 5x P/E discount for small caps relative to large caps is a historic outlier, comparable to the tech bubble of the early 2000s, which was also followed by meaningful small cap outperformance as the valuation disconnect normalized. Even if a recession were to occur over the next twelve months, small caps may not see their typical underperformance from here as the potential downside seems to largely be already priced into valuation multiples, similar to the 2000-2002 period. If there is additional downside for small cap stocks, it positions them for further outperformance in the subsequent recovery rally coming out of the recession as relative valuations become even more attractive.

 

Chart 2: Forward P/E Ratios for S&P 500, S&P 400, and S&P 600, Source: Yardeni Research

Declining inflation is a tailwind for stocks broadly, and particularly small caps

Periods of declining rates of inflation have historically corresponded with strong returns for the stock market, as investors look forward to relatively more favorable Federal Reserve policy, lower interest rates, and tailwinds to consumer spending. Since 1926, the S&P 500 has, on average, returned 14.9% in years when inflation is slowing, outperforming the average 8.7% return in periods with rising inflation. The performance difference is even more meaningful for small cap stocks, which since 1980 (the beginning of data availability for the small cap index) have generated annual returns of 15.1% in years with decelerating inflation compared to 6.8% in years when inflation accelerated. (Source: Shaker Investments, Intrinsic, Bloomberg, and Slickcharts)

As Chart 3 shows, inflation peaked in June 2022 at over 9.0% YoY in the current cycle, and the disinflationary process has begun. The yearly change in the CPI most recently moved below 5.0% YoY in March 2023. It is widely expected to continue to move lower over the remainder of 2023 and in the following years, although there is much debate as to exactly how quickly the rate returns to a more normal range near the Federal Reserve’s target of 2.0%. As long as inflation continues to move lower and we do not see an unwelcome reacceleration before returning to the more normal range, history suggests that stocks, particularly small cap stocks, tend to do well in such an environment.

 

Chart 3: S&P 500 and Consumer Price Index (CPI) YoY % change, 1973 – Present, Source: Intrinsic Research

Conclusion

While there is no crystal ball when it comes to stock market performance, our experience at Shaker Investments guides us to recommend longer term investors take a close look at their small cap allocations as they position for the next 3-5 years. Small cap stocks offer a historically rare risk-reward set-up with valuations near historic lows at ~13x Forward P/Es, combined with the tailwind of declining inflation. Bear markets have historically been unpredictable in terms of their length and breadth, but with small cap stocks 26% below their prior peak and 18 months into the current bear market, we believe now is the time to start dollar cost averaging into small cap stocks to take advantage of the better times ahead when the new bull market begins (if it hasn’t already started).

It's a Popup Test

Andrew Frye

Research Analyst

Andrew first joined Shaker in 2022 as an intern on the research team. Following his internship, Andrew accepted a full-time position with Shaker Investments as a Research Analyst. Andrew’s primary role is to work with the Portfolio Managers on monitoring existing ideas, tracking competitors, and new idea generation. Andrew brings an analytical approach to modeling companies.

Prior to joining Shaker Andrew worked as a summer analyst intern with Progressive Insurance in the Real Estate Control Group. Andrew received his BA in Economics, Political Science, and Business Management and his Masters of Business Analytics and Intelligence from Case Western Reserve University.

Ashley Arsena, CFP®

Senior Business Development and Client Service Officer

Ashley's journey with Shaker began in 2016 where she quickly established herself to be an integral part of the team. From handling operations to executing trades and providing top-notch client services, Ashley has showcased her versatile skill set. Currently, a vital member of the Business Development and Client Services team, she dedicates her days to building strong relationships with both existing and potential clients.

Ashley is a CERTIFIED FINANCIAL PLANNER™ professional. She has earned a Certificate in Financial Planning from New York University School of Professional Studies and received her BA in Business Management from Baldwin Wallace University with a minor in Human Resources.

Ashley was recognized on AdvisorHub's 100 Women Advisors to Watch in 2024 (#29) and Top 50 Woman Advisors to Watch in 2023 (#48). She has also been recognized as a Five Star Wealth Manager by Five Star Professional in 2024.

Ashley currently serves on the board of Hope for Kids Geauga. She is also an active member of CFA Society of Cleveland, serving as a member of the Women's Advisory Committee.

Ashley lives in Bainbridge with her wife Jessica and young children Connor and Avery.

*Participating in the ranking is free and AdvisorHub received no compensation from participating advisors. To read more about Advisor Hub's methodology and to view the full list please click here.

Chris Hemmelgarn

Portfolio Manager and Research Analyst

​Chris is a Portfolio Manager and Research Analyst at Shaker Investments. He is responsible for researching new and existing investments as well as portfolio management at Shaker Investments. He joined Shaker in 2017 and covers a range of companies and sectors with a focus on technology, financial services, energy, and utilities.

Prior to joining Shaker Investments, Chris worked in Sell-Side Research as a Vice President at Barclays covering Semiconductors. His primary responsibilities included company and market analysis and forecasting, publishing research, client marketing, and relationship management of company and industry contacts. He also worked as an Associate at Morgan Stanley developing and analyzing business management metrics.

Chris earned his MBA (with Distinction) specializing in Finance and Corporate Finance at the NYU Stern School of Business. He also received his BSFS in International Politics from Georgetown University.

Chris is an avid golfer and cook, and is learning the joy of maintaining a 100-year-old home after a decade plus in Manhattan apartments.

Sasha A. Kostadinov, CFA

Portfolio Manager and Research Analyst

Sasha is co-manager of the Small Cap Portfolio and conducts research on consumer discretionary, consumer staples, materials, and health care sectors for all of the portfolios at Shaker Investments. He has spent more than twenty years working in the equity markets, the last nineteen with Shaker Investments.

Prior to joining Shaker Investments, he was a research analyst at Clarion Group, a Cleveland, Ohio-based long-short hedge fund. Prior to that, he was a research analyst at KeyBanc Capital Markets (formerly McDonald Investments). Prior to that, Sasha was a Financial Consultant at Smith Barney.

Sasha is a holder of the Chartered Financial Analyst designation and received his BA in Economics and Political Science and MA in Economics at Cleveland State University.

He and his wife, Ruthann, reside in Lakewood with his guitars.

Raymond J. Rund

Managing Director, Senior Research Analyst

Ray is the Senior Research Analyst and has been covering the technology and industrials sectors since joining Shaker Investments in 1996. 

Prior to joining Shaker Investments, Ray was a General Partner in an early-stage venture capital partnership for nine years, where he organized the first round of venture funding for RF Micro Devices and served on their board for six years prior to the company’s IPO. In 2015 RF Micro merged with Triquint Semiconductor to become Qorvo, a leading supplier of integrated circuits used in wireless communications.  Ray also headed marketing at Keithley Instruments, was a consultant at McKinsey & Company, and worked in engineering and marketing for Intel. Early in his career Ray worked as an engineer for Combustion Engineering and Westinghouse Electric in Pittsburgh.

Ray currently serves on the Investment Committee of the Harvard Business School Club of Northeast Ohio, is a member of the Finance and Investment Committee of the Jewish Federation of Cleveland, and serves on and was former chair of the Retirement Fund Committee for the Jewish Federation of Cleveland.

Ray earned his BS, magna cum laude in Engineering & Applied Science at Yale University, an MS in Electrical and Computer Engineering at Carnegie Mellon University, and an MBA from Harvard University.

Ray is a long time Clevelander, and an avid Lake Erie sailor. He and his wife Jeanne live in Shaker Heights where they enjoy being close to their three adult children and grandson. 

Kacie Wick

Chief Compliance Officer

Kacie joined Shaker Investments in 2011 as the company’s controller. In 2022, Kacie was promoted to Chief Compliance Officer. She brings over 20 years of professional experience in operational and financial management for various for-profit and non-profit organizations in Boston and Cleveland.

Prior to joining Shaker Investments, she was Director of Clinical Research Administrative Operations in the School of Medicine at Case Western Research University where she managed a research grant portfolio of over $40 million. She has also worked as the Director of Finance for the Weatherhead School of Business at Case Western Reserve University, Director of Operations at Village Preparatory School; Operations Manager at Northeast Ohio Council on Higher Education; and Center Financial Manager at Education Development Center.

Kacie received her Masters of Accounting from Case Western Reserve University, where she graduated magna cum laude and her BS in Management from Babson College in Wellesley, MA. Kacie is currently working towards her Investment Advisor Certified Compliance Professional (IACCP) designation.

Kacie currently serves as a trustee for the Tod Homestead Cemetery in Youngstown, Ohio and is a former treasurer for her local girl scout Troop 70204 and the Onaway PTO. She lives in Shaker Heights with her two daughters.

Brandon A. Hemmelgarn

Co-Chief Investment Officer and Portfolio Manager

Brandon is the co-Chief Investment Officer at Shaker Investments. With over 14 years of industry experience, Brandon leads the investment team at the firm. He is also responsible for researching new and existing investments and portfolio management for all three of the firm’s strategies. Prior to being promoted to co-Chief Investment Officer in 2020, Brandon was a Portfolio Manager and Research Analyst at the firm for 8 years. He covers a range of companies and sectors including technology, consumer products and services, industrials, and materials.

Prior to joining Shaker, Brandon worked on the investment team at Audax Group, a Boston-based private equity firm focused on growing middle market companies.

Brandon is a former board member of the Washington Association of Money Managers and the Private Equity Association of Boston.

Brandon received his BA, summa cum laude, in Economics from Princeton University and is a Registered Investment Advisor Representative (FINRA Series 65). He and his wife, Shelby, reside in Arlington, Virginia, with their sons Thomas and Ted. When time permits, Brandon still enjoys lacing up his skates and taking to the ice rink.

Bradley Wheeler

President

Brad Wheeler is the President of Shaker Investments.  With more than twenty-five years of experience in the financial service industry, he is responsible for overseeing the firm’s strategy, business development and operations.  Prior to being named President, Brad served as Vice President and Head of Business Development for Shaker.  He has spent over twenty years in the financial service industry calling on endowments, pension funds and institutional investors.

Prior to joining Shaker Investments, Brad was a founding partner at Cleveland Research Company where he developed institutional relationships with clients in Boston and opened the firm’s London office.  Prior to that, Brad was a partner with FTN/Midwest Research and worked at US Bank in commercial banking.

Brad is currently a member of the Association for Corporate Growth in Greater Cleveland.  He is the prior President of the Shaker Youth Hockey Association and Shaker Heights High School Sports Boosters.

Brad received his BA in Public Finance from Miami University and an MBA from Case Western Reserve University, Weatherhead School of Management.

He and his wife, Laura, reside in Shaker Heights and have two adult children.

Edward P. Hemmelgarn

CEO & Co-Chief Investment Officer

Edward Hemmelgarn is the CEO and Co-Chief Investment Officer at Shaker  Investments. Edward’s primary focus is leading the investment team as well as portfolio management for all three of Shaker’s strategies. His research focus includes healthcare, financial services, and real estate.

Prior to founding Shaker Investments in 1991, Edward was the Chief Financial Officer of Retail Banking at Ameritrust Corporation (now KeyBank). Prior to that, Edward worked at Ernst & Young focusing on mergers and acquisitions and strategic and financial management consulting.

He received a BA in Chemistry and a MBA from the Case Western Reserve University, where he also served as an instructor for numerous courses. Mr. Hemmelgarn is a former CPA.

Edward is currently a board member at the Cleveland Museum of Art. Edward is also on the Visiting Committee of Case Western Reserve University’s College of Arts and Sciences. He is a past recipient of the Outstanding Alumni Award from Case Western Reserve University’s Weatherhead School of Business. He was named Accounting Alumnus of the Year in 2003, and a recipient of Case Western Reserve University’s Department of Chemistry’s Distinguished Alumnus Award in 2016.

Edward and his wife, Jan, reside in Shaker Heights.