Since we put out our notes outlining a small-cap outperformance thesis on June 28th, the Russell 2000 Growth (representing small-cap) is up 9.5% from June 30th through October 31st versus the NASDAQ (large-cap technology) and the S&P 500 (heavily weighted in mega-cap technology stocks) returning -0.4% and 2.3% respectively. Our client account composites are up 12.9%, 14.5%, and 12.8% across the various groups we classify based on risk tolerance. There are tangible reasons for this which we have outlined in the past and will recap here.
As we note here outperformance may be explained by the fact that these companies in the Russell 2000 are relatively underfollowed, may be growing faster due to a smaller base, may become acquisition targets for larger companies, and have a greater exposure to the US domestic economy compared to international. These factors can all be true, but what is absolutely true is that Small Cap stocks are still less than 4% of the US equity market when it normally has been over 7%. A simple reversion to the mean would account for outperformance as these under-allocated time periods.
Another possible reason why small has been performing better than large since June 30th is the last two earnings seasons have been better. In the second quarter, the gap between actual and consensus earnings expectations (which are set by analysts based on company commentary and fundamental analysis) came in at 5.2% for small versus 1.8% for large. On July 14th, we highlighted projected earnings growth for the rest of the year and 2023 here. While we cannot predict the future the numbers so far are very encouraging.
Small cap outperformance has traditionally happened in cycles, which are shown in Table 1. We have lived through these environments in the past and believe we are seeing the early innings of one of these cycles. Small cap valuations are attractive, M&A activity is strong, and we believe our portfolio is well suited to weather any storm that may come. We intend to remain focused and most of all, patient in order to capture every bit of what is hopefully a long small-cap outperformance cycle.
DISCLOSURES: This letter is not an offer to buy or sell securities. Past performance is not indicative of future returns. Securities that GROW Funds LLC purchases or sells in the future may not equal the performance of the securities described in this letter, or even be profitable at all. The securities described in this letter do not represent all of the securities purchased or sold for client portfolios.