Why small-cap value now

Persistently high inflation, the Federal Reserve’s hawkish response to it and geopolitical risks have ramped up market volatility and investor uncertainty. But Senior Portfolio Manager Stephen Gutch believes small-cap value stocks should continue to offer the potential for outperformance through each of these challenges. Here’s why:

• Higher inflation typically is a result of economic strength And small-cap value stocks and their orientation toward cyclical sectors such as Energy and Materials tend to do well during periods of above-trend growth, as is the case currently. In fact, over rolling 5- and 10-year periods since 1932, small-cap value equities have outperformed the Consumer Price Index more often than any other asset class.¹ That said, the small value universe is enormous, and much of it can underperform, particularly in turbulent markets. So, beyond making the most of small value’s cyclical leanings, active managers need to be selective. Quality is paramount. Regardless of industry, companies with pricing power, abundant free cash flow, competitive advantages, customer loyalty and manageable debt levels offer the potential to do better relative to the broader market when inflation is running high.
• Prior to 2021, small-cap value stocks were out of favor for years And they continue to trade at a substantial discount relative to other asset classes even after the past year’s relative outperformance. When compared to the broad market, the valuation of small value stocks today is more than 29% lower than its average over the last 20 years. That gap widens to over 40% when comparing small value to small growth.² Of course, valuation isn’t the sole driver of investment performance; you need earnings growth as well. In an economy that we believe is at the midpoint of its growth cycle, there is tremendous earnings growth potential in the small value universe. This combination of attractive valuations and strong earnings growth bodes well, especially for quality companies running on all cylinders.
• Periods of rising interest rates typically accompany a strengthening economy And small-cap stocks in general tend to outperform during such periods because improving economic conditions have an outsized positive impact on the ability of smaller companies to grow earnings and enhance their balance sheets. (Similarly, falling rates during periods of economic deceleration tend to have an outsized negative impact.) For example, from 1979-2020 the Russell 2000 Index generated average annual returns that were 2 percentage points higher than the S&P 500 when yields on U.S. 10-year government bonds were rising, and relative performance has been even stronger during periods when the 10-year Treasury yield rises by more than 50 basis points³—similar to the environment we find ourselves in today.
• Geopolitical eruptions such as the Ukraine war present international risk And small-cap stocks—particularly small value—tend to be somewhat insulated from global events given their U.S. focus. Companies in the small-cap value universe derive approximately 83% of their revenue from within U.S. borders,⁴ substantially more than large, multinational firms.

To be sure, no company is immune from extreme macroeconomic or geopolitical events—we can’t predict or control the macro. But as active managers, we can seek to add value by determining what—and what not—to own.

¹ Source: Furey Research Partners, FactSet, Morningstar comparing performance of small value, small growth, large value, large growth, T-Bills, T-Notes, T-Bonds, corporate bonds, high-yield bonds and gold from 1932 to 2021. Example cited is for illustrative purposes only and is not indicative of any specific investment.

² Small value vs. market compares current 12-month forward P/E of Russell 2000 Value Index relative to S&P 1500 index versus the 20-year median relative valuation from 3/15/2002 to 3/15/2022; Small value versus small growth performs same calculation using Russell 2000 Value Index versus Russell 2000 Growth Index. Source: FactSet

³ Source: Furey Research Partners citing performance from 1979 to 2020.

⁴ Source: FactSet as of 12/31/2021.