Why US small caps are ready to add value
In a year largely defined by volatility, it seems almost fitting that the small-cap market is subject to extremes in 2020, says Francis Gannon.
After starting the year with the largest quarterly loss on record in over 40 years, the Russell 2000 Small Cap Index had three positive quarters and continued to grow.
The first quarter of this year was the second consecutive solid for the Russell 2000 Index, which rose 12.7%. This robust result also drove the Small Cap Index to a near record one-year return (through March 31, 2021) of 94.8%, giving investors a particularly stark sign of a full recovery in the markets. US scholarship challenge and pain caused by the coronavirus pandemic.
Small caps remain much cheaper than their national large cap peers, as measured by EV / EBIT, enterprise value / earnings before interest and taxes. ”
Confidence measured amid mixed signals
The transition in the last twelve months from recession to recovery and expansion is apparently being factored in in many small-cap companies. Yet, as the shift to sustained economic expansion continues, the tussle between expectations and underlying fundamentals is likely to be the critical factor in determining the continuation of multiple expansion.
For many sectors of the small cap universe, the market seems to be rediscovering the importance of earnings. After a period of below-average economic growth, profits are just beginning a robust recovery, with many industries still well below pre-Covid levels.
The recent rotation of leadership from large caps to small caps looks sustainable. While it’s indisputable that small-cap valuations ended March near all-time highs, this needs to be weighed against the fact that these wealthy valuations are based on what will likely be a bottom of profits in what. remains a very low interest rate environment.
In addition, small caps remain much cheaper than their domestic large cap counterparts, measured by EV / EBIT, enterprise value / earnings before interest and taxes.
The nascent global economic recovery, fueled by reopenings, fiscal and monetary stimulus, and pent-up consumer demand, is in turn spurring the revitalization of value and cyclicals within small caps.
So while the recent pace of returns is clearly unsustainable, we believe there are other reasons to stick with the asset class beyond our expectations of improving corporate performance. high quality.
The highs of the current period are somewhat new, but the experience of high returns from small caps is not.
This is the case even in a market where valuations are high across the entire stock market. To get a better idea of what might happen next, we looked at the one-year small-cap results that tracked the top 10 12-month high returns for the quarter-end periods.
The record for the next 12 months is decidedly mixed, ranging from double-digit gains to declines between teens and teens. Based on history, therefore, the Russell 2000 could either walk on water, experience a correction or two, or continue to advance, albeit at a significantly slower pace, over the next year or so.
The subsequent three-year periods, however, tell a much better, more consistently positive story, with consistently positive average annualized results. The Russell 2000’s three-year average return after its 10 strongest four-quarter periods is 11.9% versus 10.3% for all three-year rolling quarterly returns since inception. We believe this historic model should hold up.
Support signals with endurance
Despite rich valuations, there are several contrasting positive factors, each of which is likely to last. The housing market remains strong, consumer balance sheets are in excellent shape, the scale of the fiscal stimulus is likely to expand – perhaps with significant infrastructure spending and the Fed has signaled that it is not. was no longer as concerned about the overheating inflation on the economy, reversing the view he held in recent years.
So, as the pace of small-cap returns slows, positive results seem likely, with history pointing to the possibility of low double-digit returns on an annualized basis over the next several years.
We also believe that we are reaching the point where corporate results will diverge, giving disciplined active managers the opportunity to add value.
Francis Gannon is Co-Director of Investments at Royce Investment Partners, which is part of Franklin Templeton.