Will Small-Cap Value’s Outperformance Continue?—Royce
article 01-26-2022

Will Small-Cap Value’s Outperformance Continue?

Senior Investment Strategist Steve Lipper looks to the data to explain why the small-cap value rally may have some way to go.


Small-cap stocks have had a dismal start to 2022. Still, though the Russell 2000 Value Index was down 7.0% through 1/21/22, it continued to significantly outperform the Russell 2000 Growth Index, which declined 15.9%, through that same date. This year-to-date performance advantage extended small-cap value’s substantial 2021 outperformance over small-cap growth, up 28.3% versus 2.8%, respectively. Will small-cap value’s leadership continue? We think it’s likely for several reasons that we outline below.

One reason for continued leadership for small-cap value is that significant differences exist in economic exposures among value and growth portfolios, which are proxied by the meaningful differences in composition between the two small-cap styles indexes. Additionally, when we meet with investors we often find they are surprised by the historically frequent wide performance spreads between the Russell 2000 Value and Growth Indexes. Yet divergent performance between the two styles is actually “normal,” which is to say that it’s the historical norm. We think that once investors understand these historical patterns, as well as others we’ll highlight, they’ll appreciate why we believe that the current small-cap value rally has some way to go.

Let’s begin looking at the historical calendar year performance spread of the Russell 2000 Value versus the Russell 2000 Growth since their 1979 inception. We believe that investors often aren’t aware that in most calendar years (72%), the spread between the two indexes has been meaningful, at least 5%, and in nearly half of the calendar years (47%), there’s been a difference of at least 10% in performance between the two indexes. The frequency and magnitude of these performance differences suggests, at least to us, that each is driven by distinct factors related to how their composition interacts with economic conditions. For this reason, it might be useful for allocators to think of small-cap value and small-cap growth as two related, but distinct asset classes.

Russell 2000 Value – Russell 2000 Growth Calendar Year Total Return Performance
From 12/31/78 through 12/31/21

Russell 2000 Value – Russell 2000 Growth Calendar Year Total Return Performance

Past performance is no guarantee of future results

Looking under the surface to each index’s composition reveals certain factors that help explain why returns have varied so much over the last 40-plus years. The two industry groups where the Russell 2000 Value is most overweight compared with the Russell 2000 Growth are banks and real estate, both notable beneficiaries of inflation and cyclical activity. These industry groups, particularly banks, are also often highly weighted in active small-cap value portfolios. Conversely, the three industry groups where the Russell 2000 Value is most underweight—software & services, pharmaceuticals, biotechnology & life sciences, and health care equipment & services—are areas that have historically struggled in higher inflation environments and tend not to participate in cyclical expansions. Our observation is that these three areas are also often lightly weighted in active small-cap value portfolios. This compositional analysis corroborates our inference that, with such large and frequent spreads, the performance of each small-cap style index is heavily influenced by different economic environments.

Russell 2000 Value vs Russell 2000 Growth Top Three Underweights and Overweights by Industry Group
As of 12/31/21

Value vs. Growth Underweights

Looking back in time reveals the depth of decline that small-cap growth has already endured. The Russell 2000 Growth peaked roughly a year ago on 2/9/21 and has declined more than 26% since that high through 1/21/22, while the Russell 2000 Value has risen a modest 3.4% over the same period. With all of the absolute and relative discomfort that small-cap growth investors have endured over the past year, those investors may be hoping that this underperformance period will soon be coming to an end. While that’s possible—all expectations about the future are uncertain—history would suggest that small-cap growth’s underperformance could continue for years.

For example, let’s revisit the experience of the 2000-2006 period. In that market cycle, the Russell 2000 Growth peaked on 9/1/00. In an even worse relative experience than the current market cycle, the small-cap growth index then declined 35.7% in the 12 months after its peak, while the Russell 2000 Value advanced 17.7% over the same period. After that difficult year, small-cap growth investors might have expected that their relative return woes were behind them. The market, however, had other ideas. Over the five years following that first year (9/1/01-9/1/06), the Russell 2000 Growth produced a modest annualized return of 6.2%, while the Russell 2000 Value continued its winning ways over the same period, posting an annualized return of 14.1%.

In early 2000’s, after a Painful First Year, Small-Cap Growth Continued to Lag


Russell 2000 Value and Russell Growth at 1-year ended 9/1/01 and then the next 5 years ended 9/1/06

R2K Growth Index peaked on 9/1/00
Past performance is no guarantee of future results

How might that experience of 20 years ago be relevant to current conditions? One key insight to take from this historical comparison is that a single year of extreme underperformance does not necessarily signal the end of an underperformance period. We were struck by the fact that even after small-cap value’s approximately 25% outperformance spread in 2021, the Russell 2000 Value still lagged the Russell 2000 Growth for both the trailing 3- and 5-year periods ended 12/31/21—in the latter case by more than 500 basis points. This result stands in stark contrast to the average return spread for all five-year periods, which is about 300 basis points in favor of small-cap value. So, we seem to have further to go for the Russell 2000 Value to fully revert to its historical outperformance of the Russell 2000 Growth over multi-year periods, which also suggests that the difficult times for small-cap growth investors may last longer than its adherents would like.

Small-Cap Growth’s Recent 5-Year Outperformance Contrasts with Historical Pattern

5-years ended 12/31/21 and average of all 5-year periods ended 12/31/78

Past performance is no guarantee of future results

Our expectations for small-cap value’s continued outperformance are based on three observations: First, the prospective economic environment of above-average economic growth and above-average inflation favors the overweighted areas within small-cap value and hinders those groups with greater exposure within small-cap growth. Second, the historical relative return profile favors a return to small -cap value leadership and a continuation of outperformance, even after a large performance gap over the past year. Finally, as we have noted elsewhere, despite its significant 2021 outperformance, small-cap value is still priced near the bottom of its 20-year valuation range compared with small-cap growth. For all these reasons, we think that small-cap growth investors, despite their recent performance pain, might want to consider a re-allocation to small-cap value, as we think there may be years left in this current outperformance trend for small-cap value.



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.

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.

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.

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