Typically, when climbing out of an economic crisis, equity markets will rise in anticipation of a stronger economy and small cap stocks will tend to outperform their larger cap cousins.
This is largely due to the fact that a stronger economy is generally a better stage for new products and services. When this is coupled with credit that tends to be cheaper and more readily available for these smaller companies, it increases investor’s appetite for “riskier” investments.
In my view, within this premise, small cap value stocks should have an active if not over weighted role in an asset allocation portfolio. In their career defining three factor model research, Noble Laureate Eugene Fama and Kenneth French argued that small-cap stocks have historically outperformed the broader market.1 Their research includes the belief that investors misprice the value of these smaller companies, and are willing to pay up for growth and for blue-chip stocks.
Of course, on the surface, our current market crisis seems to shatter this historic research as we have been fighting our way back from the economic shutdown of the U.S. and world economies due to Covid-19.
I took a look at the year to date performance, as of this past Friday, June 5, of several indices using iShares ETFs as a proxy, and here is what I found.
iShares S&P 500 Growth (IVW) +7.30%
iShares Russel 2000 Growth (IWO) -(1.37%)
iShares S&P 500 Value (IVE) -(8.90%)
iShares Russel 2000 Value (IWN) -(17.19%)
The performance of small cap value going into the Covid Crisis and now emerging from it, seems to pale in comparison to large cap, but this may be presenting a strong opportunity for this asset class.
Sam Stovall, chief investment strategist at CFRA, in a research note at the end of May pointed out that the S&P 500 index is expected to trade at 23.2 times projected earnings for the next 12 months, according to S&P Capital IQ consensus estimates.2 He notes that is 41% above its average P/E ratio of 16.5 since 2000.
In contrast, iShares is showing that as of June 4, the iShares Russell 2000 Value ETF is trading at a P/E of 12. Does that make small cap value stocks cheap?
It is interesting that as markets hit bottom in late March of this year, the Russel 2000 Value index traded at levels not seen since 2007. In contrast, the Russel 1000 Growth index only went back to 2018 levels at its bottom and is now on the doorstep of erasing all loses from its high. The iShares Russel 1000 Growth ETF (IWF) is up 8.55% for 2020 as of Friday June 5.
If historically, small cap value stocks tend to significantly outperform coming out of a bear market* and based on current delta of valuations for small cap value and large cap growth stocks, does this suggest that an allocation in small cap value is warranted based on its historical performance?
Perhaps, the answer lies in the amount of outperformance small cap value has achieved when compared to large cap coming out of a bear market.
To illustrate this point I turn to a brilliant piece written by Ben Carlson on April 7, 2020 entitled, What Happened to Small Cap Value. In this piece he uses the Fama and French study to see the scope of outperformance small cap value has delivered and the numbers are eye popping.
He wrote, “Using S&P 500 bear markets going back to the late-1920s, I looked at the performance of the S&P and small cap value stocks coming out of these periods over the ensuing one, three and five year periods:
He then took a look at the last two bear markets to add credence to the longer-term historical study results.
In my view, we do not know if we are out of the woods yet relative to the market and Covid-19, but the Fama French research seems to imply the power of small cap value stocks coming out of a crisis. Based on current valuations, the wisdom of an allocation in this asset class or even an overweight might make sense.
As I see it, if you want to add further returns to this strategy, your key will be to find an active manager that has demonstrated a historical propensity to outperform the benchmark.
For more on this topic, please call our desk at 858 964 – 0500.
Performance data quoted represents past performance. Past performance does not guarantee future results.
*A bear market is defined as a market that is down 20 percent or more. A bull market is defined as a market that is up 20 percent or more.
** The Russell 2000 Index is designed to measure the performance of the small capitalization companies in the United States equities market. The index is a composite of roughly 2,000 securities issued by companies with market capitalization values averaging $2 billion. The Russell 2000 Value Index is a subset of the securities found in the Russell 2000
*** The Russell 1000 Growth Index is designed to measure the performance of large-cap growth oriented equities. The index contains securities with a greater than average growth orientation.
****This data is a representation of the S&P 500 including dividends. The S&P 500, is a stock market index based on the market capitalizations of 500 large companies having common stock listed on the NYSE or NASDAQ. The S&P 500 Index components and their weightings are determined by S&P Dow Jones Indices. It differs from other U.S. stock market indices, such as the Dow Jones Industrial Average or the Nasdaq Composite index, because of its diverse constituency and weighting methodology. It is one of the most commonly followed equity indices, and many consider it one of the best representations of the U.S. stock market, and a bellwether for the U.S. economy. You cannot invest directly in an index.
As with all investments, there is the risk that you could lose money through your investment. There is no assurance that a fund will meet its investment objective.
Small Capitalization Risk – Investments in small cap companies carry more risks than investments in larger companies. Small cap companies often have narrower markets, fewer products, or services to offer and more limited managerial and financial resources than do larger, more established companies.