In each of the past three calendar years, small cap stocks in the U.S. have lagged their large cap counterparts by roughly 6-7% per year. This trend accelerated even more dramatically in the first quarter of 2020 as small caps underperformed large caps by over 10%—a magnitude larger than any quarter over the past 40 years, including the golden years of megacap growth leadership in the late 1990s.1

Understandably, investors in 2020 have been concerned that small businesses would be irrevocably damaged by government-mandated lockdowns intended to stem the global COVID-19 pandemic, which was reflected in a peak-to-trough decline of nearly 42% for the Russell 2000® Index in under 20 trading days. With these losses still fresh on our minds, what should investors consider when deciding both their long-term strategic allocation to small cap equities as well as what tactical opportunities may exist over the next few years?

Long-term allocations

On a strategic basis, the case for maintaining a long-term allocation to small cap equities remains strong. Russell Investments’ 10-year strategic asset class forecasts put both global and U.S. small cap equities near the top of the pack for expected absolute returns, second only to emerging market equities.2 While investors should remain aware that this higher expected return likely comes with a higher level of annualized volatility, we maintains the view that small cap stocks are an important source of growth for return-seeking investors that provide diversification benefits relative to large cap companies, both domestically and abroad.

Near-term opportunities

Moving on to the nearer term opportunity in small caps, our investment process centers on the consideration of three key variables for dynamic portfolio management tilts: cycle, valuation and sentiment.

Cycle
According to analysis completed by BofA Merrill Lynch, the absolute performance of small cap equities since 1979 has been most correlated with macroeconomic indicators of domestic economic activity, consumer and business owner sentiment and investor risk appetite. When these metrics are increasing, typically so are small cap stocks. With global economic activity grinding to a halt in early 2020, the underperformance of small cap stocks has held true to these historical relationships. However, as governments around the world have unleashed vast monetary and fiscal stimulus—in many cases targeted directly at ensuring the viability of small businesses through low or zero interest loans and forgivable grants—the forward-looking picture becomes more positive.

Notwithstanding the risk of a potential setback on COVID-19 infection and death rates as economies reopen around the world, the data released thus far during the second quarter—namely, improving leading economic indicators, lower unemployment and the contraction of high-yield spreads—are all likely to be wind at the back of small cap stocks. Additionally, the potential for the pendulum of globalization reversing course in favor of reshoring could prove bullish for small caps over an even longer horizon. As highlighted in a recent blog post by my colleague Mike Smith, history has demonstrated that coming out of economic recessions, market leadership can and often does change. Indeed, in the 15 occurrences of a business cycle trough since 1926, the more cyclical orientation of smaller cap equities has driven outperformance over the subsequent 12 months of 8.4%, on average, with a hit rate of 87%.3

Emotions can be a serious threat to an investor's financial health. Which is why it's important to know how to keep your head above water in the cycle of investor emotions.

Valuation
Between stunning market volatility and a record number of companies pulling estimate guidance in 2020, what investors are paying for small cap stocks (and what they are getting for their money) has become increasingly unclear. The forward P/E (price-to-earnings) multiple on the Russell 2000® Index has swung wildly from a trough of 11x in late March (the lowest level since February 2009 and 20% below its long-term average) to a near-record high of over 19x today. The cause of today’s expensive P/E multiple is due both to both the dramatic second quarter rally in equity markets (the numerator) and the relatively few sell-side analysts who cover small cap stocks slashing their earnings estimates (the denominator) in a vacuum of company guidance. So, does that mean small caps aren’t a good value? Not necessarily.

First, small caps entered 2020 trading at their largest discount to large caps in the past 18 years and continue to be on offer for a lower multiple of expected earnings than large caps’ 21x.

Second, the level of valuation dispersion among small cap stocks has spiked to over five standard deviations above average4, which means that there is a historically high level of opportunity to build a portfolio of undervalued securities within the small cap space. In doing so, investors need to be aware that, even before the pandemic-induced recession we currently find ourselves in, over a quarter of companies in the Russell 2000 Index were unprofitable and debt levels among small caps had swelled well beyond leverage levels during the GFC (Global Financial Crisis).

As these statistics for small caps overall will likely get worse in the coming quarters, it reinforces the need for a discerning eye in selecting which stocks to include in one’s portfolio to make sure that the price paid accurately reflects the case-by-case situation of each small business through this tumultuous time. With nearly 60% of Russell 2000 companies having five or fewer sell-side analysts covering them (compared to just 1% for S&P 500 companies), today’s market environment provides ample opportunity for skilled stock pickers to separate the small cap wheat from the chaff. Again, in the 10 occurrences of a spike in valuation spreads since 1926, smaller cap equities have outperformed over the subsequent 12 months by an average of 4%, with a hit rate of 90%.5

Sentiment
As noted at the beginning, sentiment for small cap stocks relative to large caps has been poor for quite some time. Investor preference and resulting price momentum has been decidedly in favor of megacap growth names, a trend that is accentuated as incremental dollars are passively invested only according to current market capitalization (bigger begets bigger). This trend even accelerated during the first-quarter sell-off as many of those business models thrived under stay-at-home orders.

However, of the CVS trio, sentiment is the one that can turn on a dime. While surely too early to call a trend, we have seen evidence in recent weeks that incremental buyers are increasingly turning their attention toward smaller, cyclical companies, with the greatest acceleration potential in a global economic recovery driving small cap stocks up nearly 24% versus large caps’ 20% during the second quarter’s historic rally.6 This again rhymes with the 23 occurrences of market recoveries since 1926 where smaller cap equities have outperformed over the subsequent 12 months by an average of 10.5%, with a hit rate of 83%.

The bottom line

As shared with readers a few weeks ago, we expect the road to recovery to be uneven. In this environment of uncertainty, no one should be surprised to find that the performance of small cap stocks may acutely reflect those forward, backward and side steps along the way. However, small caps remain one of the most fruitful and diversifying strategic allocations within the return-seeking portfolios of both institutional and individual investors alike. Additionally, the current opportunity afforded by the very nascent phase of the world’s next economic cycle, large valuation spreads and early indications of a shift in sentiment build a compelling case for considering a tactical allocation to small caps as well.


1 Source: Russell 2000® Index, S&P 500® Index
2 Source: Russell Investments research
3 Source: Russell Investments research
4 Source: National Bureau of Economic Research, Empirical Research Partners Analysis
5 Source: Russell Investments research
6 Source: Russell 2000® Index, S&P 500® Index

Disclosures

These views are subject to change at any time based upon market or other conditions and are current as of the date at the top of the page.

Investing involves risk and principal loss is possible.

Past performance does not guarantee future performance.

Forecasting represents predictions of market prices and/or volume patterns utilizing varying analytical data. It is not representative of a projection of the stock market, or of any specific investment.

This material is not an offer, solicitation or recommendation to purchase any security. Nothing contained in this material is intended to constitute legal, tax, securities or investment advice, nor an opinion regarding the appropriateness of any investment, nor a solicitation of any type.

The general information contained in this publication should not be acted upon without obtaining specific legal, tax and investment advice from a licensed professional. The information, analysis and opinions expressed herein are for general information only and are not intended to provide specific advice or recommendations for any individual entity.

Please remember that all investments carry some level of risk. Although steps can be taken to help reduce risk it cannot be completely removed. They do no not typically grow at an even rate of return and may experience negative growth. As with any type of portfolio structuring, attempting to reduce risk and increase return could, at certain times, unintentionally reduce returns.

Investments that are allocated across multiple types of securities may be exposed to a variety of risks based on the asset classes, investment styles, market sectors, and size of companies preferred by the investment managers. Investors should consider how the combined risks impact their total investment portfolio and understand that different risks can lead to varying financial consequences, including loss of principal. Please see a prospectus for further details.

Indexes are unmanaged and cannot be invested in directly.

The Russell 2000® Index measures the performance of the small-cap segment of the U.S. equity universe. The Russell 2000 Index is a subset of the Russell 3000® Index representing approximately 10% of the total market capitalization of that index. It includes approximately 2000 of the smallest securities based on a combination of their market cap and current index membership.

The S&P 500® Index, or the Standard & Poor's 500, is a stock market index based on the market capitalizations of 500 large companies having common stock listed on the NYSE or NASDA

Russell Investments' ownership is composed of a majority stake held by funds managed by TA Associates with minority stakes held by funds managed by Reverence Capital Partners and Russell Investments' management.

Frank Russell Company is the owner of the Russell trademarks contained in this material and all trademark rights related to the Russell trademarks, which the members of the Russell Investments group of companies are permitted to use under license from Frank Russell Company. The members of the Russell Investments group of companies are not affiliated in any manner with Frank Russell Company or any entity operating under the "FTSE RUSSELL" brand.

Copyright © Russell Investments Group LLC 2020. All rights reserved.

This material is proprietary and may not be reproduced, transferred, or distributed in any form without prior written permission from Russell Investments. It is delivered on an “as is” basis without warranty.

UNI-11698

© Russell Investments

Read more commentaries by Russell Investments