Small-Cap Stocks: Things to Consider Now
Cambiar Small Cap Portfolio Managers Andy Baumbusch and Colin Dunn answer a few questions about the state of small-cap stocks.
What has been going on with Small Cap stocks over the last few years?
Andy: While small-cap stocks have outperformed their large-cap counterparts by over 100% on a cumulative basis over the last 20 years, this trend has reversed more recently. As of 9.30.19, the rolling 3-year performance gap (~5% annualized) between the Russell 2000 and the Russell 1000 indices is the widest over the past two decades. The last time we saw a gap that surpassed even the 4% threshold, small-cap stocks outperformed large caps by over 1200bps over the following 12 months (source: Morningstar).
As co-managers of the Cambiar Small Cap Value portfolio, we note the divergence and see a number of considerations for existing and prospective clients to mull.
How has recent relative underperformance influenced Small Cap Valuations?
Colin: Relative to large-cap, small-cap stocks appear attractively valued, and though absolute small-cap valuations have compressed vs. late 2017 peaks, they stand slightly above historic averages on metrics such as P/E and P/B. Small-cap stocks are not alone in this regard, as equities across the market cap spectrum (and many other asset classes) are valued at the upper end of their historical ranges. We believe the elevated multiples for equities are partially attributable to the persisting generationally low discount/fixed income rates.
Barra Earnings Yield Factor
The Earnings Yield Factor is a value proxy that incorporates a number of valuation ratios:
- Cash Earnings/Price
On this basis, Small Cap stocks are at their cheapest point relative to Large Cap since 2003.
What is critical for investors to consider – given where we are in the current market cycle?
The universe of quality stocks has been winnowed substantially and must be evaluated with appropriate fundamental research care.
Andy: While we are only ever fully able to grasp point in cycle in hindsight, Cambiar is cautious on the remaining duration of this U.S. economic and credit expansion – particularly given the combination of historically high aggregate debt levels (corporate and sovereign) and a deceleration in economic growth. The rising tide environment that has been in place for much of the past ten years effectively placed a low premium on security selection. Yet we believe that selectivity will be paramount moving forward. Within the small-cap asset class, the median long-term debt-to-capital level has been steadily increasing since the Great Financial Crisis and is currently at its highest point in 20 years. In addition, approximately 37% of Russell 2000 constituents have no earnings – another high watermark for non-recession periods. Of the remaining 60+% “earners”, valuations in many cases are in fact that much higher – the universe of quality has been winnowed substantially, and must be evaluated with appropriate fundamental research care. Given this collective backdrop, adopting a passive approach to achieving small-cap exposure would seem particularly ill-considered.
Any final thoughts?
Colin: On balance, Cambiar believes the small-cap asset class may be poised to experience a period of relative outperformance vs. large-cap peers, and such exposure is better achieved via active management than passive alternatives. The attributes that accompany active management – significant vigilance, a bias toward a selective, well-researched basket of stocks that have demonstrated the ability to navigate both positive and negative economic growth scenarios, consistent financial returns – should take on renewed importance in the coming years. Above average profitability, supported by market position, persistent cash flow and low leverage are longstanding criteria for the companies that comprise the Cambiar Small Cap Value portfolio and remain that which we continue to target.
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Russell 1000 Index: The Russell 1000® Index is a float-adjusted, market capitalization-weighted index that measures the performance of the 1,000 largest companies in the Russell 3000® Index, which consists of 3,000 of the largest U.S. equities.
Russell 2000 Index: The Russell 2000® Index is a float-adjusted, market capitalization-weighted index that measures the performance of the 2,000 smallest companies in the Russell 3000® Index, which consists of 3,000 of the largest U.S. equities.