Franklin Small Cap Value Fund Portfolio Manager Steve Raineri discusses why he thinks the near-record underperformance of higher- quality, profitable small-capitalization (small-cap) value stocks relative to lower-quality, unprofitable companies could present a compelling opportunity for longer-term investors as the US economy continues to recover from the COVID-19 pandemic.

During a broad COVID-19 equity market selloff in March and April, US small-cap stocks were hit particularly hard.1 At the time, many investors seemed especially concerned about how these companies would fare in a US economic slowdown.

Since then, many small-cap stocks, as represented by the Russell 2000 Index, have rallied from April’s lows as the US government and Federal Reserve’s rapid response to the COVID-19 crisis helped lift markets. Small-cap stocks especially benefited from the development of multiple vaccines and hopes for fiscal stimulus; quarterly performance was the best on record, allowing the index to reach all-time highs.2 However, lower-quality, less-profitable companies have largely driven it. Given the index’s most recent performance, some investors have asked us for our views on a potential sustained rally in small-cap stocks.

While we remain optimistic regarding the outlook for small-cap stocks, with the returns from unprofitable companies far in excess of profitable ones and near historical extremes3 (see charts under Reason #3), we believe investors should begin to focus on quality at this point in the cycle. Here, we outline five reasons we think small-cap stocks, particularly those with quality characteristics, are worth considering.

Reason # 1: Compelling Valuations

Despite a bounce off the lows, at the end of January 2021, small-cap value stocks in the Russell 2000 Value Index were trading near their lowest levels in 10 years, compared to the large-cap value stocks in the Russell 1000 Value Index, as measured by price-to-earnings (P/E) ratios.4 See chart below.

We see a few reasons for this difference in valuations, including the belief mentioned above that all small-cap stocks are more susceptible to a US economic downturn. While that’s true for many stocks in the Russell 2000 Value Index, it’s not true for all of them, particularly select small-cap value stocks with higher margins, lower leverage and decent earnings growth.5