Navigating Small Cap Stocks in a Falling Rate Environment: Opportunities and Risks
As we have seen the Bank of Canada cut rates and we anticipate the US Federal Reserve to do the same in the coming months, we are starting to expect that we will soon be in a full-on falling rate environment, where most major central banks around the world are cutting interest rates. In the past two weeks, we have started to see the Russell 2000 (the index in the US that tracks small cap stocks) have a significant increase in its price after it has seen a significant lag in price performance with the S&P 500. We know that small cap stocks are deemed a riskier play due to their size and higher potential for failure. However, with these two factors currently in play, we wanted to analyze what we can typically expect to see from small cap stocks in a falling rate environment and what drives them to act like this.
Lower Borrowing Costs: Small cap companies typically have higher debt ratios and rely more on borrowing to finance their growth. This is one of the largest reasons that we start to see the decrease or increase in a stock price for small caps. Based on their market capitalization and where they are in their life cycle, these companies are much more typically in the start-up stage and are more reliant on debt than more mature companies. When rates decrease, we start to expect that these types of companies are going to be able to increase their profits more. The reason behind this uptick in profits is that a lot of their debt used to finance their companies is of the variable variety. As central banks cut rates, we can expect that their borrowing costs will decline, improving their overall bottom line. These companies will also have easier access to capital, which should help them increase their growth rate by spending more money on assets to grow the business. With these lower borrowing costs in place, this should help their overall business in many different ways. If they have good management in place, this should lead to an increase in stock price.
Increased Risk Appetite: One factor that can drive investors and their shift of money into riskier stocks like small caps is an increase in risk appetite for overall returns. As rates start to be cut, we would expect to see products like GICs and bonds start to lower their returns to investors over time, leading to a shift of their money into more equity-based strategies. This will typically lead to more money flowing into the small cap areas than usual. We currently still live in a world where GIC rates are high compared to where they have been over the last decade. This can be a move that investors get out in front of if they believe the rate cuts will continue and be significant over this rate-cutting cycle.
Valuation Multiples Expansion: Lower interest rates reduce the discount rate used in valuation models, leading to higher present values of future cash flows. This can result in higher valuation multiples for small cap stocks, making them more attractive to investors. This is where these companies start to make more sense by making more money and attracting more investors into their stocks as the fundamentals of these stocks continue to look better.
Enhanced Merger & Acquisitions Activity: With cheaper borrowing costs, larger companies and private equity firms are more likely to engage in mergers and acquisitions. Small cap stocks typically benefit from this type of activity as they are the main targets for this behavior from large & mega cap stocks looking to grow their business. As interest rates decrease, we would expect to see the amount of merger & acquisitions increase, which should help the stock prices of small cap stocks. As we have seen investment banks like Goldman Sachs report earnings lately, they have mentioned expecting an increase in the mergers & acquisitions area of their business, which supports the theory that this market behavior could lead to higher prices for certain small cap stocks.
In conclusion, a falling rate environment creates a scenario for small cap stocks that appears to be incredibly favorable historically, providing multiple avenues for potential growth and increased valuations. With lower borrowing costs, these companies can access the capital needed to expand and innovate, while an increased risk appetite among investors drives more funds into the sector. Additionally, the expansion of valuation multiples and heightened merger and acquisition activities further enhance the appeal of small cap stocks. As interest rates continue to decline, we can expect these dynamics to play a significant role in the performance of small cap stocks, making them an attractive option for investors seeking higher returns in a changing economic landscape. It is important to note that investing in small cap stocks comes with a higher risk level, and a higher risk tolerance is needed to invest in this space. Keeping an eye on these trends and understanding their implications can help investors make informed decisions and capitalize on the opportunities presented by a falling rate environment.
As we still wait on the US Federal Reserve to make their first cut, we need to be aware that the market is a voting machine and typically will move before the interest rates start to decline. Given the recent sentiment shift that the US Federal Reserve will cut rates and the recent uptick we have seen in the Russell 2000, this was a topic worth exploring today.
The information contained herein has been provided by MacMillan Keeping Wealth Management and is for[SI1] information purposes only. The information has been drawn from sources believed to be reliable. The information does not provide financial, legal, tax or investment advice. Particular investment, tax, or trading strategies should be evaluated relative to each individual's objectives and risk tolerance. Certain statements in this document may contain forward-looking statements (“FLS”) that are predictive in nature and may include words such as “expects”, “anticipates”, “intends”, “believes”, “estimates” and similar forward-looking expressions or negative versions thereof. FLS are based on current expectations and projections about future general economic, political and relevant market factors, such as interest and foreign exchange rates, equity and capital markets, the general business environment, assuming no changes to tax or other laws or government regulation or catastrophic events. Expectations and projections about future events are inherently subject to risks and uncertainties, which may be unforeseeable. Such expectations and projections may be incorrect in the future. FLS are not guarantees of future performance. Actual events could differ materially from those expressed or implied in any FLS. A number of important factors including those factors set out above can contribute to these digressions. You should avoid placing any reliance on FLS. MacMillan Keeping Wealth Management is part of TD Wealth Private Investment Advice, a division of TD Waterhouse Canada Inc. which is a subsidiary of The Toronto-Dominion Bank. ®The TD logo and other TD trademarks are the property of The Toronto-Dominion Bank or its subsidiaries.
Lower Borrowing Costs: Small cap companies typically have higher debt ratios and rely more on borrowing to finance their growth. This is one of the largest reasons that we start to see the decrease or increase in a stock price for small caps. Based on their market capitalization and where they are in their life cycle, these companies are much more typically in the start-up stage and are more reliant on debt than more mature companies. When rates decrease, we start to expect that these types of companies are going to be able to increase their profits more. The reason behind this uptick in profits is that a lot of their debt used to finance their companies is of the variable variety. As central banks cut rates, we can expect that their borrowing costs will decline, improving their overall bottom line. These companies will also have easier access to capital, which should help them increase their growth rate by spending more money on assets to grow the business. With these lower borrowing costs in place, this should help their overall business in many different ways. If they have good management in place, this should lead to an increase in stock price.
Increased Risk Appetite: One factor that can drive investors and their shift of money into riskier stocks like small caps is an increase in risk appetite for overall returns. As rates start to be cut, we would expect to see products like GICs and bonds start to lower their returns to investors over time, leading to a shift of their money into more equity-based strategies. This will typically lead to more money flowing into the small cap areas than usual. We currently still live in a world where GIC rates are high compared to where they have been over the last decade. This can be a move that investors get out in front of if they believe the rate cuts will continue and be significant over this rate-cutting cycle.
Valuation Multiples Expansion: Lower interest rates reduce the discount rate used in valuation models, leading to higher present values of future cash flows. This can result in higher valuation multiples for small cap stocks, making them more attractive to investors. This is where these companies start to make more sense by making more money and attracting more investors into their stocks as the fundamentals of these stocks continue to look better.
Enhanced Merger & Acquisitions Activity: With cheaper borrowing costs, larger companies and private equity firms are more likely to engage in mergers and acquisitions. Small cap stocks typically benefit from this type of activity as they are the main targets for this behavior from large & mega cap stocks looking to grow their business. As interest rates decrease, we would expect to see the amount of merger & acquisitions increase, which should help the stock prices of small cap stocks. As we have seen investment banks like Goldman Sachs report earnings lately, they have mentioned expecting an increase in the mergers & acquisitions area of their business, which supports the theory that this market behavior could lead to higher prices for certain small cap stocks.
In conclusion, a falling rate environment creates a scenario for small cap stocks that appears to be incredibly favorable historically, providing multiple avenues for potential growth and increased valuations. With lower borrowing costs, these companies can access the capital needed to expand and innovate, while an increased risk appetite among investors drives more funds into the sector. Additionally, the expansion of valuation multiples and heightened merger and acquisition activities further enhance the appeal of small cap stocks. As interest rates continue to decline, we can expect these dynamics to play a significant role in the performance of small cap stocks, making them an attractive option for investors seeking higher returns in a changing economic landscape. It is important to note that investing in small cap stocks comes with a higher risk level, and a higher risk tolerance is needed to invest in this space. Keeping an eye on these trends and understanding their implications can help investors make informed decisions and capitalize on the opportunities presented by a falling rate environment.
As we still wait on the US Federal Reserve to make their first cut, we need to be aware that the market is a voting machine and typically will move before the interest rates start to decline. Given the recent sentiment shift that the US Federal Reserve will cut rates and the recent uptick we have seen in the Russell 2000, this was a topic worth exploring today.
The information contained herein has been provided by MacMillan Keeping Wealth Management and is for[SI1] information purposes only. The information has been drawn from sources believed to be reliable. The information does not provide financial, legal, tax or investment advice. Particular investment, tax, or trading strategies should be evaluated relative to each individual's objectives and risk tolerance. Certain statements in this document may contain forward-looking statements (“FLS”) that are predictive in nature and may include words such as “expects”, “anticipates”, “intends”, “believes”, “estimates” and similar forward-looking expressions or negative versions thereof. FLS are based on current expectations and projections about future general economic, political and relevant market factors, such as interest and foreign exchange rates, equity and capital markets, the general business environment, assuming no changes to tax or other laws or government regulation or catastrophic events. Expectations and projections about future events are inherently subject to risks and uncertainties, which may be unforeseeable. Such expectations and projections may be incorrect in the future. FLS are not guarantees of future performance. Actual events could differ materially from those expressed or implied in any FLS. A number of important factors including those factors set out above can contribute to these digressions. You should avoid placing any reliance on FLS. MacMillan Keeping Wealth Management is part of TD Wealth Private Investment Advice, a division of TD Waterhouse Canada Inc. which is a subsidiary of The Toronto-Dominion Bank. ®The TD logo and other TD trademarks are the property of The Toronto-Dominion Bank or its subsidiaries.
