The pending Fed pivot sees the central bank reversing course from monetary accommodation to tightening as well as moving to raise rates, the latter being deployed to combat inflation. The potential effects of these policy shifts are being weighed against a host of other challenges, including the pandemic’s continued grip over the global economy, a tangle of fraught geopolitical tensions, and global supply chain delays.

In this context, equities have been highly volatile so far in 2022. The Russell 2000 Index has had a dismal start to the year—its worst since 2009. The small-cap index began 2022 accelerating a slide that began in November 2021 before entering an “official” bear market (that is, a decline of 20% or more) in late January. At its year-to-date 2022 low, the average stock in the Russell 2000 Index was off more than 40% from its 52-week high. So far this year, 10 out of 11 small-cap sectors are in the red, with Health Care leading the decline and only Energy in positive territory.

Russell 2000 Sector Returns
From 12/31/21 Through 2/16/22 (%)

To be sure, sentiment across the equity landscape remains quite negative, and investors are positioned for—and seem to be expecting—the worst. Yet one must wonder when sentiment and headlines will take a back seat to fundamentals.

Ironically, from our perspective, the current period is an almost perfect environment for active managers with an absolute and long-term orientation like ourselves. Expectations are low, and valuations are attractive. As we have seen and heard in many fourth quarter 2021 earnings reports, fundamentals are clearly better than the dire headlines would suggest. While the small-cap earnings season is far from complete, results have generally been stronger than expected. As we have highlighted before, however, one clear risk is how companies weigh current robust demand against the potential inability to fulfill orders, which creates challenges for companies to effectively manage both longer wait times for fulfillment and their order books. We continue to speak with companies frequently as to how they’re managing this delicate balance.

Perhaps the current reporting season’s most interesting development has been the divergence between earnings beats and misses, as even low valuation, low expectation stocks—which would usually have some shelter if they missed since little was anticipated—were drastically punished. At the same time, other companies are making what we think is the smart decision amid the uncertainty surrounding inflation and global supply chains to tamp down expectations. To this end, we have also seen full year 2022 earnings estimates for small caps decline from more than 22% estimated growth at the start of the year to around 16% currently. Our expectation is that these 2022 earnings estimates should increase again as we progress through the year given continued global economic strength and further clarity around many of the macro headlines of the moment. The markets only need the whisper of a few potential catalysts for the “glass-half empty” sentiment to reverse quickly and for fundamentals to come into focus.

While there is no easy answer to the question of what happens next, we have always believed in the critical importance of focusing on what we know and not worrying about what we cannot control. Using history as our guide, we know that since 1945, based on data from CRSP, small-cap stocks have posted positive annualized three-year returns 88% of the time on a rolling monthly basis, with an average return in the low double digits. Moreover, we know that small-caps have an impressive record of rebounds from declines of 20% or more from a previous peak. The recent January 2022 low marked the twelfth such decline since the 1979 launch of the Russell 2000. The average subsequent one-year return from the first day of the eleven previous declines was 19.6%.

We believe that active management will become more important through this volatile market and that earnings will ultimately drive individual company stock returns. The earnings prospects for many small-cap companies remain promising, specifically those with sound fundamentals, including low-debt balance sheets, positive cash flows, and the ability to pass on higher costs in this inflationary period. While we recognize that near-term market performance may be less than optimal, we also understand that the current environment presents an opportunity to find bargains that will drive results for the next three to five years.

Stay tuned…

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