Will This Small Value Cycle Last?—Royce
article 05-11-2021

Will This Small Value Cycle Last?

Senior Investment Strategist Steve Lipper provides four reasons why he believes that small-cap value will continue to lead.


Among the most common questions we’re hearing from clients currently is, “Will small-cap value’s recent outperformance last?” While developing a response about any future market direction is challenging, the long-awaited value resurgence has frustrated as many of us as it’s pleased, feeling at times like a perpetual disappointment reminiscent of Waiting for Godot. Is it really here? Will it stay with us? We think the answers are ‘yes,’ and here are our reasons.

Economic Cycle

Small-cap value has had a pronounced tendency to outperform small-cap growth when nominal economic growth is above average. In our studies, nominal growth, as measured by nominal GDP, provides a more promising signal than real growth in terms of style leadership. Our hypothesis is that small-cap value is both more cyclically sensitive than its growth sibling in addition to being a greater beneficiary of inflation for relative earnings growth and valuation. We looked back over the past 20 years and found that in one-year periods with at least 5% nominal GDP growth, the Russell 2000 Pure Value Index outperformed the Russell 2000 Pure Growth Index 68% of the time by an average of 420 basis points. In contrast, when nominal GDP growth fell between 3-5%, the small-cap value index outperformed only 32% of the time and lagged small-cap growth by an average of 100 bps. This is especially relevant to the current environment because consensus projections call for nominal GDP growth in the 8-10% range for 2021 and 5-7% for 2022. And additional fiscal spending would likely raise those projections.

Strong Economic Expansion Has Favored Value
Rolling 12 Month Returns for the Russell 2000 Pure Value vs Russell 2000 Pure Growth Indexes from 3/31/01 to 3/31/21.

Pre Value and Pure Growth GDP

Past performance is no guarantee of future results.

Compositional Differences

The difference in relative performance influenced by the level of economic growth makes sense when one looks at the compositional differences in the respective small-cap style indexes. We find that comparing weightings at the industry group level, one level below sectors, is most illuminating. Compared with small-cap growth, small-cap value’s three largest industry group overweights are:


All three of these areas can be expected to benefit from a cyclical recovery as well as a moderate increase in inflation. In contrast, small-cap value’s three largest industry group underweights are:


All three of these areas are more defensive and would not be expected to participate in the cyclical recovery. Of course, active managers are not restricted to how the indexes define value and growth, but in our experience, active value and growth portfolios tend to mirror the over and underweights listed above. So the economic growth environment, combined with the compositional differences between the value and growth indexes, would seem to support a sustainable period of leadership for small-cap value.

Relative Valuation

Even after small-cap value’s recent strong performance, it remains significantly undervalued compared with small-cap growth. In fact, using our preferred valuation metric, Enterprise Value/Earnings Before Interest and Taxes (EV/EBIT), small-cap value was at its lowest relative valuation versus growth in 20 years at the end of the quarter. We think this extreme relative valuation spread suggests that there’s more to come of small-cap value’s outperformance.

Small-Cap Value Sells at Its Lowest Valuation to Growth in More Than 20 Years
Russell 2000 Value and Growth Shifted Median Relative LTM EV/EBIT1
Russell 2000 Value/Growth from 3/31/01 to 3/31/21
ussell 2000 Value/Growth from 3/31/01 to 3/31/21

1 Last twelve months enterprise value/earnings before interest and taxes.
Past performance is no guarantee of future results.
Source: FactSet

Style Leadership Persistence

Small-cap value has so handily outperformed small-cap growth over the past six months (by 25.7%) that some investors have asked us whether there would be a trend reversal to growth leadership or a trend persistence of value leadership. We did some historical research to see when value led growth by comparably large amounts, using 700 bps over trailing six-month periods as our measure, to examine the subsequent experience. We found that the existing leadership trend for value has historically persisted. More specifically, in the subsequent 12 months, after an outperformance period of at least 700 bps, value beat growth 71% of the time by an annualized average of 820 bps; in the subsequent three-year periods, value beat growth 69% of the time by an annualized average of 460 bps.

When Small-Cap Value Has Outpaced Small-Cap Growth by a Large Spread (7%) over Six Months, Value’s Outperformance Often Continued.
Monthly Rolling Subsequent One- and Three-Year Russell 2000 Value Performance Following a High Six-Month Return Spread From 12/31/78 through 3/31/21

Value vs. Growth

Past performance is no guarantee of future results.

Based on this historical pattern, the recent burst of small-cap value outperformance looks less like the end of a trend and more like the beginning of a long-term—and long-awaited—leadership phase.


To answer the initial question, because of the current phase of the economic cycle, the compositional differences between value and growth, the extreme spread in relative valuation, and the historical pattern of trend persistence after large spreads in value outperformance, yes, we think that small cap value will continue to lead.



Important Disclosure Information

Mr. Lipper’s thoughts and opinions concerning the stock market are solely their own and, of course, there can be no assurance with regard to future market movements. No assurance can be given that the past performance trends as outlined above will continue in the future.

The performance data and trends outlined in this presentation are presented for illustrative purposes only. Past performance is no guarantee of future results. Historical market trends are not necessarily indicative of future market movements.

Sector weightings are determined using the Global Industry Classification Standard ("GICS"). GICS was developed by, and is the exclusive property of, Standard & Poor's Financial Services LLC ("S&P") and MSCI Inc. ("MSCI"). GICS is the trademark of S&P and MSCI. "Global Industry Classification Standard (GICS)" and "GICS Direct" are service marks of S&P and MSCI.

Cyclical and Defensive are defined as follows: Cyclical: Communication Services, Consumer Discretionary, Energy, Financials, Industrials, Information Technology, and Materials. Defensive: Consumer Staples, Health Care, Real Estate, Utilities.

Frank Russell Company (“Russell”) is the source and owner of the trademarks, service marks and copyrights related to the Russell Indexes. Russell® is a trademark of Frank Russell Company. Neither Russell nor its licensors accept any liability for any errors or omissions in the Russell Indexes and / or Russell ratings or underlying data and no party may rely on any Russell Indexes and / or Russell ratings and / or underlying data contained in this communication. No further distribution of Russell Data is permitted without Russell’s express written consent. Russell does not promote, sponsor or endorse the content of this communication. All indexes referenced are unmanaged and capitalization-weighted. The Russell 2000 Pure Value Index is an unmanaged index composed of securities with strong value characteristics selected from the Russell 2000 Index. Securities are weighted based on their style score. For the Russell 2000 Pure Value and Pure Growth Indexes all performance presented prior to the index inception on April 7, 2015 is back-tested performance. Back-tested performance is not actual performance, but is hypothetical. The back-test calculations are based on the same methodology that was in effect when the index was officially launched. However, back-tested data may reflect the application of the index methodology with the benefit of hindsight, and the historic calculations of an index may change from month to month based on revisions to the underlying economic data used in the calculation of the index. The Russell 2000 Pure Growth Index is an unmanaged index composed of securities with strong growth characteristics selected from the Russell 2000 Index. Securities are weighted based on their style score. The Russell 2000 Value and Growth indexes consist of the respective value and growth stocks within the Russell 2000 as determined by Russell Investments. The performance of an index does not represent exactly any particular investment, as you cannot invest directly in an index.

This material is not authorized for distribution unless preceded or accompanied by a current prospectus. Please read the prospectus carefully before investing or sending money. Smaller-cap stocks may involve considerably more risk than larger-cap stocks. (Please see "Primary Risks for Fund Investors" in the prospectus.)



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