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Small-cap value: Strong past, bright future?

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2024-01-31
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The views expressed are those of the authors at the time of writing. Other teams may hold different views and make different investment decisions. The value of your investment may become worth more or less than at the time of original investment. While any third-party data used is considered reliable, its accuracy is not guaranteed. For professional, institutional, or accredited investors only.

Although broad equity markets have struggled lately, we continue to believe in the long-term case for small-cap value investing and see a timely opportunity to consider adding to small-cap value allocations today.

Small, but mighty

Small-cap names may not be as well-known as the titans dominating large-cap indices, but they have a formidable history. Not only have small-cap stocks historically outperformed their larger peers, but they’ve done so strongly, by an annual average of more than 300 basis points (bps), and consistently, more than 69% of the time (Figure 1). 

Figure 1
small-cap-value-strong-past-bright-future-fig1

We observe a similar performance dispersion between the value and growth style factors. Historically, value-oriented stocks have outperformed growth counterparts both strongly, by an annual average of more than 400 bps, and consistently, more than 90% of the time (Figure 2).

Figure 2
small-cap-value-strong-past-bright-future-fig2

The small-cap value asset class has also achieved better earnings growth and capital returns than other asset classes, including small-cap growth, large-cap value, and large-cap growth, while maintaining attractive valuations. In fact, small-cap value stocks have traded at depressed price-to-earnings ratios compared to those other asset classes for the better part of the past decade. 

Looking ahead, there’s reason to believe in small-cap value stocks’ future potential, as well. Analyst coverage in this space is comparatively low. Nearly 85% of small-cap stocks are covered by fewer than 10 sell-side analysts, compared to 33% of mid-cap stocks and 6% of large-cap names. 

This lower volume of research and coverage of the space gives active managers greater ability to seek out potential “hidden gems” among smaller companies and generate positive excess return. Historically, active managers have maintained an edge in small-cap investing. On a 10-year basis, the median small-cap manager has notably outperformed US small-cap equities, proxied by the Russell 2000 Index, by 0.94% on average, in 71% of the trailing periods.

Why small-cap value now?

We think now may be a good time to revisit small-cap value allocations, as our favorable long-term view is paired with depressed valuation levels, creating a potentially attractive entry point for the asset class.

Historically, small-cap value stocks have outperformed small-cap growth over the forward 10-year period when growth has beaten value over the trailing 10-year period (Figure 3). As illustrated in the top left quadrant of Figure 3, through the end of 2021, historically, value has always outperformed in the 10 years following a 10-year period of growth outperformance. Right now, we’re at the end of a 10-year period of growth outperformance, which suggests that the tide may turn, and we could be entering a period of value strength.

Figure 3
small-cap-value-strong-past-bright-future-fig3

We’re also facing the onset of what seems to be a significant economic regime shift. Dynamics like consistently low inflation and relatively low interest rates, which underpinned relative market strength for the past decade, began to crumble in 2022. The current market environment is characterized by higher inflation and rising interest rates — shifts we view as harbingers of shorter and more volatile market cycles. This economic shift could provide a return tailwind for value stocks and help narrow the current valuation gap with their growth counterparts.

Small-cap value: The big picture

We believe there’s a compelling case to be made for small-cap value. The asset class has traditionally performed well versus larger asset classes and against growth-oriented equities. And relatively few analysts cover this space, which, in our view, creates significant opportunity for active managers to add value. Beyond this strategic case for the asset class, now may be a compelling time for investors to consider an allocation. Shifting market dynamics could further support small-cap value equities, potentially boosting relative returns and narrowing or closing their valuation discount to other segments of the equity market.

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