Higher interest rates have hampered the share price performance of growing smaller companies. But interest rates have not necessarily impacted operating performance of these companies. With inflation falling, rates peaking and corporate earnings growing, small cap valuations are attractive.
Interest rates and the cost of capital are key to the performance of growing smaller companies. Most investors buy smaller companies for growth, not for value. There are several reasons for this, including:
• The risks of buying a lower growth model at a cheap valuation are higher in smaller companies
• Balance sheets are more vulnerable
• Business models are more focused and less diversified
• Liquidity is a challenge, so investors may find selling the shares expensive or difficult to execute if bad news breaks
This means it is safer to focus on quality and growth, buying reliable business models with sustainable and repeatable earnings, and ultimately strong growth. The trade-off is that such companies command higher valuations. These factors are always important, but become more so when interest rates are high, and when the economic background deteriorates.