Pounding the Table for Small-Caps
article 07-26-2022

Pounding the Table for Small-Caps

Senior Investment Strategist Steve Lipper looks at why challenging times like the present can ultimately reward small-cap investors.



We can appreciate that small-cap investors, having just endured the worst first half in the more than 40-year history of the Russell 2000 Index, a loss of 23.4%, may be reticent to put fresh capital to work in the asset class. We also understand the weariness and anxiety of investors as they contemplate the current landscape of potential recession, multi-decade highs in inflation, an aggressive Federal Reserve, and continued geopolitical turmoil. There seem to be many good reasons not to invest now. Yet that perception is exactly why we are so emphatic that, based on a collection of indicators that we watch, this looks like an extremely attractive time to invest in small-caps, particularly if an investor uses large-cap stocks as source of funds.

Let’s begin with some observations about current valuations within the U.S. equity market that we think reveal some unappreciated insights. The chart below features two components—current valuations, measured with our preferred metric of enterprise value divided by earnings before interest and taxes and a comparison to the 25-year average of the same metric for the nine size/style segments of the U.S. equity market (e.g., small/mid/large, value/core/growth) as proxied by the relevant Russell Index. To our eyes, five salient insights appear:

1) The Russell 2000 Small-Cap, Value, and Core Indexes are the cheapest segments of the U.S. market  

2) These are the only segments that are below their 25-year average valuation 

3) While all three value segments across the capitalization ranges of small-, mid-, and large-cap have nearly identical 25-year average valuations, their current valuations are vastly different 

4) The Russell 2000 and 1000 Indexes have nearly identical 25-year average valuations, yet quite different current valuations 

5) Large-Cap and Mid-Cap Growth valuations still have a long way to go before reaching their 25-year average valuations

Small-Cap Value and Small-Cap Are the only Indexes Cheaper than Their Historical Average
Current and 25-Year Average Median EV/EBIT (ex-Negative EBIT)1 Levels for Russell Indexes as of 6/30/22 

 Style Index EV to EBIT Median

1Enterprise value divided by earnings before interest and taxes.

These valuation differences are particularly relevant now because it seems likely that U.S. equity valuations have hit their peaks for many years to come. Our view is that a future environment featuring somewhat higher interest rates and inflation, along with a less accommodative Federal Reserve and increased geopolitical rivalries, combine for a greater risk environment. This new climate will therefore probably see somewhat lower equity valuations than we have seen over much of the last ten years. The investment consequence of this view is that investors should allocate away from higher valuation assets, which may have stiff headwinds to appreciation, into lower valuations assets, which may benefit from at least a neutral environment or perhaps modest tailwinds.

We next examine a less well-known dynamic between large- and small-cap stock performance as investor fear waxes and wanes. We have found it useful to monitor the CBOE S&P 500 Volatility Index “VIX” Index as a barometer for risk tolerance. Long-time investors will know that risk tolerance ebbs and flows with various events. However, regardless of the event (e.g., Long-Term Capital Management’s 1998 meltdown, 9/11, the Great Financial Crisis of 2008-09, the Greek Debt Crisis in 2011, 2020’s COVID shutdown), risk tolerance initially plummets before investors show their resilience and acclimatize to the new development, leading to a normalizing of risk tolerance.

This is the history of markets. Yet there’s also a consistent pattern within U.S. equities as small-cap stocks seem to absorb a greater proportion of heightened fear than large-caps as stock prices fall. However, this phenomenon creates an opportunity, as the chart below highlights. Periods of high investor anxiety, as proxied by the VIX index, have historically been attractive entry points for absolute small-cap returns and, even better, often excellent entry points for small-cap outperformance over large-caps. When the VIX has had an average monthly reading of 25 or more, as it did in June, the subsequent three-year annualized returns for small-caps have been 14.1%, compared with 9.4% for large-caps. Even more striking than the spread of outperformance has been the batting average—that is, the frequency of time when small-caps have beaten large-caps over the subsequent three years from similar staring points—which is 83%. We have characterized small-caps as being similar to a coiled spring in times of high investor anxiety, contracting more as fear increases and bouncing back more robustly as fear recedes.

Subsequent Average Annualized Three-Year Return for the Russell 2000 Starting in Monthly Rolling VIX Return Ranges 
From 12/31/89 to 6/30/22 
Past performance is no guarantee of future results. 
Batting Average refers to the percentage of three-year periods in which the Russell 2000 Index outperformed the Russell 1000 Index.  

There’s another subtle aspect of the small-cap asset class that highlights its breadth and heterogeneity. It is common to use indexes as proxies for asset classes—as we do with the Russell 2000—but indexes are a very rough guide. For a large universe of companies with a variety of idiosyncratic developments, the performance of an index may obscure what else is going on in the overall universe. We have found this dynamic often manifests itself in small-cap market declines in which the index decline often understates the peak to trough decline of the average stock. We have calculated the past patterns of the decline of the average stock in the Russell 2000 from respective 52-week highs, and then the subsequent returns based on the depth of decline starting point.

As can be seen in the chart below, and as might be expected, the deeper the decline for the average Russell 2000 stock, the higher the subsequent average return. However, echoing the observation we made above about small-caps’ relative returns from periods of heightened fear, the batting average of small-caps beating large-caps over the subsequent three-year following deep decline periods, has been an impressive 92%. Those observations were from all subsequent three-year periods when the average Russell 2000 stock was down 32% or more from respective 52-week highs. The current small-cap market is in an even more depressed state. While the Russell 2000 was down 29.5% from its 52-week high at quarter end, the average small-cap stock was 44% off its 52-week high.

Subsequent Average Annual Three-Year Return for the Russell 2000 Based on Average Stock Decline From 52-Week High Range  
From 12/31/96 to 6/30/22

Past performance is no guarantee of future results.
Batting Average refers to the percentage of monthly three-year periods in which the Russell 2000 Index outperformed the Russell 1000 Index. 

From our perspective, this triumvirate of historically grounded observations—small cap’s superior valuation, the history of small-cap outperformance following high fear moments, and the relative outperformance of small-caps from points of deep decline—make a compelling, if not table pounding, case for putting fresh capital into small-caps now, possibly using large cap as a source of funds.

We think small-cap investors are well-advised to follow the investment maxim, “Look to be fearful when others are greedy and greedy when others are fearful.”

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.

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 Index is an index of domestic small-cap stocks that measures the performance of the 2,000 smallest publicly traded U.S. companies in the Russell 3000 Index. The Russell 1000 Index is an unmanaged, capitalization-weighted index of domestic large-cap stocks. It measures the performance of the 1,000 largest publicly traded U.S. companies in the Russell 3000 Index. The CBOE S&P 500 Volatility Index (VIX) measures market expectations of near-term volatility conveyed by S&P 500 stock index option prices. It is the square root of the risk-neutral expectation of the S&P 500 variance over the next 30 calendar days and is quoted as an annualized standard deviation. 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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