When Will Small Businesses Join The Party?

Although many companies are experiencing record sales with the stocks hitting all-time highs (e.g., Nvidia), the small business sector seems to be missing the party altogether. For several years, we have been writing about the lagging S&P 600 Small Cap Index to its peers of the S&P 500, NASDAQ, and S&P 400 Mid Cap Indices.

For the past three years, the total return of these indices has recovered from the 2022 selloff, with the exception of the Small Cap Index. Below are the three-year total returns from March 12, 2021 through yesterday:

• S&P 500: 31.37%

• NASDAQ: 21.40%

• S&P 400 (Mid Cap): 12.69%

• S&P 600 (Small Cap): -6.11%

As illustrated in the chart above, all the indices sold off during 2022, but the S&P 600 has yet to recover back above its level on March 12, 2021.

It was not much of a surprise to read in yesterday's National Federation of Independent Business (NFIB) that the small business optimism index remains below its 50-year average for the 26th consecutive month, and prior to 2020, small business owners have not been this pessimistic since 2013.

Although the NFIB Businesses Optimism index is low, there were several positive findings in yesterday's NFIB report that included:

• Reports of labor quality as the single most important problem for business owners decreased five points to 16%, the lowest reading since April 2020.

• The net percentage of owners who expect real sales to be higher increased six points from January 

• Small business owners' plans to fill open positions continue to slow, with a seasonally adjusted net 12% planning to create new jobs in the next three months, the lowest level since May 2020.

• Thirty-seven percent (seasonally adjusted) of all owners reported job openings they could not fill in the current period, down two points from January and the lowest reading since January 2021.

• The net percent of owners raising average selling prices declined one point from January to a net 21% (seasonally adjusted), the lowest reading since January 2021.

Hiring qualified employees seems to be a constant challenge for business owners. In this report, 56% of the business owners reported that they had positions open for hire in February, with 25% saying they had few qualified applicants and 26% reporting having no qualified applicants. This is encouraging for the continuation of the US economy, with more jobs pending for small businesses that will continue to improve the labor market and increase consumer spending. 

WHAT DOES IT MEAN TO ME?

Small businesses defined as having fewer than 500 employees account for 99.7% of all business in the US. Companies with fewer than 100 employees represents 98.1% and companies with fewer than 20 employees represent 89% of all businesses. Even more surprising is that 78.5% of all businesses in America have ten employees or less.

Companies with fewer than 500 employees employ 46.4% of private sector employees and represent 43.5% of the nation's Gross Domestic Product (GDP), also referred to as corporate gross revenue.  

Cities throughout America depend on their small businesses for financial stability by employing the residents of the local community and tax revenue to local agencies. The economy has fully recovered from the 2020 pandemic, with more people working in the country's history. As we have opined in this space, consumers and households are financially stable and supporting solid retail and service industries. 

However, it appears that most of the recovery has been achieved by regional, national, and domestically located international companies. The fact that small business owners remain pessimistic about their financial environment would be troubling if consumers and mid and larger companies also felt the same way. But this is not the case. Small businesses are usually the leaders of a recovery market and the best investment opportunity in the early stage of a market rally. The theory is that small businesses are more nimble and can adjust their finances and inventory more quickly than large national firms. But here again, this does not seem to be the case.

Possibly, an explanation for the lagging growth in small businesses is due to two areas:

1. Access to affordable loans

2. Competition against large companies to pay high wages for employees 

Small businesses do not have the same access to the credit markets as their larger competitors do. Small businesses simply do not have the financial strength and history that affords them the opportunity to get loans with favorable terms of duration and lower interest rates. The financial leverage for small businesses evaporated as loan interest rates soared in 2022.  

Second challenge is competing against large corporations that bumped starting wages to $20 per hour that for many small companies was reserved for employees that have some experience or a couple years with the company. Now people with no experience can walk into Starbucks, In & Out, or McDonalds and earn that amount from day one. This is challenging for small businesses with 56% indicating that they are still looking for qualified applicants.

We have been trimming our allocation to the Small Cap S&P 600 ETF index fund (SPSM) from our Up Capital Model portfolios and recently completely sold this position. We will wait until this sector is showing technical signs of outperforming its peers. Until then, we hope small business owners will be benefiting from the growing economy before the next recession.

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