It was the worst Q2 ever for the Russell 2000 and the worst first half since 1973. We would argue that this can be attributed to a general market decline due to increasing interest rates, liquidity needs of investors (margin calls), and outflows from small cap exchange traded and index funds. The decline has gone beyond what we would have anticipated. No matter the cause, at some point investors will move back to small caps. Currently, the size segment is less than 4% of the total U.S. equity market, atypical of its historical average of 7.5% (shown by the orange line in Chart 1). A simple reversion to the mean would indicate small-cap outperformance, but we believe it’s possible to go much further, as these under-allocated time periods are often followed by strong performance.
Chart 1
Source: FactSet; FTSE Russell; Center for Research in Security Prices (CSRP), The University of Chicago School of Business, Jefferies
According to a Jefferies research piece written in June 2022, their small-cap relative valuation model hasn’t seen valuations as low as these since 2003. They also highlighted the lack of interest in the small cap segment which sparks a 1999 or 2000 comparison. Furthermore, the pickup in inflation and commodity prices are like that of the 70’s when small cap stocks began their longest winning streak ever. These comparisons parallel our previous blog “Small and Microcap Securities versus Mega-caps” which outlines small-cap outperformance cycles (Table 1). While we can't predict the timing, data points like these combined with our observations of growth and valuation plus our decades of experience throughout prior cycles give us the confidence that small-cap stocks will snap back in a big way.
Table 1
Source: GROW Funds, Ibbotson, Roger
A few more data points to consider:
Within Chart 2, the orange line represents the relative performance of small cap, represented by the Russell 2000 Index, to large cap, represented by the Russell 1000 Index. The blue bars show that the relative performance is in the 11th percentile, which simply means that the small cap underperformance is at extreme levels not seen since the early 2000’s.
Chart 2
Source: Source: FactSet; FTSE Russell; Jefferies
Chart 3 reaffirms the small-cap valuation dislocation by showing that from an absolute valuation (price to earnings) perspective as represented by the green line, the last time we saw these levels was in 2020 during the depths of Covid, and late 2008 during the great financial crisis. The purple line represents 8 mega cap stocks (Google, Amazon, Apple, Meta, Microsoft, Netflix, Nvidia, and Tesla) which have considerably higher PE multiples.
Chart 3
Table 2 breaks down projected earnings growth for the rest of 2022 and 2023. We draw your attention to Small Cap Growth column in which the numbers speak for themselves. Herein lies what we believe is a tremendous opportunity.
Table 2
As of June 28th, 2022. Source: FactSet; Standard & Poor’s; Jefferies; GROW Funds LLC
None of this means anything unless we capitalize on it. If history is a guide, Small-cap stocks from a relative and absolute valuation perspective look compelling. We believe that through our process of idea generation and fundamental analysis we can capitalize on the dislocations that are currently occurring in the market. At the time of this writing the value of the top 5 names in the S&P 500 Index are 3x larger than the entire market value of all the companies in the Russell 2000 Index. In addition, the 5 names are valued at 6.8x sales versus the Russell 2000 Index at 2.2x. We have lived through these environments in the past and we believe that we are in the first inning of a multi-year small-cap outperformance cycle. We intend to stay focused and most of all, patient in order to capture every bit of what we think is coming.
Sources:
DeSanctis CFA, Steven. “JEF’s Performance Scorecard-Q2 & 1st Half Worst Ever for RUT, Reversal in June.” Jeffries USA Equity Strategy, July 1st, 2022
Yardeni, Dr. Edward, Abbott, Joe, and Quintana, Mali. “Stock Market Briefing: Selected P/E Ratios” Yardeni Research, Inc. July 12, 2022. https://www.yardeni.com/pub/stockmktperatio.pdf, Accessed July 12, 2022.
GROW Funds, Ibbotson, Roger. Stocks, Bonds, Bills, and Inflation (SBBI): 2021 Summary Edition, Research Foundation Books, 2021