Small Cap Value: A good story now could be a better story later

07-10-2014

I’d be the first to admit that small-cap value stocks haven’t been the greatest place to be the past year. For much of the period, they significantly trailed larger-cap stocks and struggled to keep up with rival small-cap growth stocks. But that has changed for the better in the past few months. Through July 9, small-cap value stocks as measured by the Russell 2000 Value Index were up 3% year-to-date. While that still trails the S&P 500, which was up 6.7% the same period, it has pushed the category well ahead of small-cap growth stocks, with the Russell 2000 Growth Index up only 0.1% over the same period. I expect small-cap value will widen this performance gap over small-cap growth stocks the remainder of the year, and potentially outperform the larger-cap S&P as well.

For one, we just had what’s known as the Russell Reconstitution, the annual size and style reclassification that Russell Investments does to all of the stocks in its indices to realign each index with its defined purpose. For small-cap value, this meant that all of the large and all of the expensive stocks that no longer fit the parameters of the Russell 2000 Value Index have been thrown out of the benchmark, and smaller and inexpensive stocks have been brought in. This annual refreshing and reloading of the asset class, which takes place at the end of every June, is a key to the Russell 2000 Value’s often superior returns, because the small value stocks coming into the benchmark are the exact ones that benefit from the small-cap and value effects, two academically supported tailwinds1 to the asset class. 

As far as the longer term, the data undeniably reflect the superior potential return characteristics of small-cap value. According to Fama-Frech data (see footnote 1, below), since 1928 through 2013, small-cap value has returned 18.9% per year on average, easily outpacing large-cap stocks and small-cap growth’s 14.1% annualized return over the same period. A great portion of this outperformance occurs during the bad times as small value doesn’t suffer the major drawdowns that hotter corners of the market often experience when the environment no longer is so hot. In other words, by doing a better job of preserving capital during periods of economic struggle, this asset class is capable of producing attractive total returns over long periods of time. This is why small value can be such a great choice for long horizon goals such as retirement or college education for your children.

Watch for regression to the mean
In addition, there is something else special going on with the asset class today. It is an unusual time in the markets. Recall that the Russell 2000 Growth Index beat the Russell 2000 Value Index by 9% last year, and has in fact beaten value in five of the last seven calendar years. This is not a normal pattern of events, and in fact is something which has never happened before in the history of the Russell data. What does this tell us? It tell us that if you believe in regression to the mean, think value. When people talk about the overvaluation of stocks or small-cap stocks at this part of the market cycle, recognize that they are primarily taking about growth stocks, and if this overvaluation were to unwind, it is reasonable to expect small value to outperform. 

OK, so of course one would expect me to be very bullish on small-cap value stocks. So don’t take my word for it—take Paul Merriman’s. The author, financial advisor and MarketWatch columnist who specializes in retirement issues recently reviewed returns for small-cap value vs. the S&P 500 for every 20-calendar-year period starting with 1934 and found of the 61 periods, small-cap value stocks beat the S&P 60 times. His conclusion: small-cap value stocks represent the one asset class that every long-term investor should consider owning. I couldn’t agree more!

1 Based on research by Nobel Prize-winning economist Eugene F. Fama, of the University of Chicago, and economist Kenneth R. French, of Dartmouth College.

Lawrence R. Creatura
Lawrence R. Creatura, CFA
Portfolio Manager

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Views are as of the date above and are subject to change based on market conditions and other factors. These views should not be construed as a recommendation for any specific security or sector.
Past performance is no guarantee of future results.
Russell 2000® Growth Index: Measures the performance of those Russell 2000 companies with higher price-to-book ratios and higher forecasted growth values. Investments cannot be made directly in an index.
Russell 2000® Value Index: Measures the performance of those Russell 2000 companies with lower price-to-book ratios and lower forecasted growth values. Investments cannot be made directly in an index.
S&P 500 Index: An unmanaged capitalization-weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries. Indexes are unmanaged and investments cannot be made in an index.
Small-company stocks may be less liquid and subject to greater price volatility than large-capitalization stocks.
Value stocks tend to have higher dividends and thus have a higher income-related component in their total return than growth stocks. Value stocks also may lag growth stocks in performance at times, particularly in late stages of a market advance.
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