Eq: Small Caps
The market has been on a tear recently, but you wouldn’t know it from looking at small caps. Despite the broader rise in indexes, the Russell 2000 has not hit a fresh high in a month. Investors are wondering why, and the reason is pretty clear: inflation fears. Small caps are not seen to have as much pricing power as their larger peers, so as input costs rise, they get hit with lower margins.
FINSUM: There is nice clear and succinct reason why small caps have been underperforming over the last month. The good news is that inflation fears are subsiding, which means small caps should rebound accordingly.
Let’s be clear, value stocks have been doing great over the last six months as growth stocks have started to fizzle. Accordingly, a lot of the small cap value stocks you could have found at the end of last summer have already risen strongly. However, there are a number of them that still look great buys according to fund managers. Here are a few names to explore: Citizens Financial Group, a strong regional bank; United Community Banks, a quick-growing regional bank; Sunstone Hotel Investors, a REIT that owns hotel buildings and leases them to big hotel chains; Herc Holdings, a construction and earth-moving equipment rental company; Marriott Vacations Worldwide Corp, a timeshare operator; and Ultra Clean Holdings, which makes chemicals and equipment for the semiconductor industry.
FINSUM: A bounce back in leisure travel is quite an interesting play for us, so Sunstone and Marriott Vacations look interesting, but all of these are worth a deeper dive.
Most investors had their eyes on growth, particularly in the rebound of the pandemic, but things are starting to look good for value stocks. Investors at Columbia Threadneedle Investments said that stimulus from the Fed and Government put investors' value metrics on pause, but as the economy continues to normalize and rates rise, value stocks will be the beneficiaries. Companies like Citizens Financial Group Inc., United Community Banks Inc., and Sunstone Hotel Investor Inc. are all small-cap value companies that Tugman of Columbia Thread Needle finds attractive. P/E ratios are better for small and mid-cap value stocks, and are trading at heavy discounts compared to the broad S&P.
FINSUM: As life returns to normal stocks might do the same, which would be a return of value investing and attractive price-to-earnings ratios.
Small caps have had a great run since the market’s bottom in March. The IWM ETF, which is the market’s effective benchmark for small cap performance has had an astonishing year. Since October alone IWM has returned 35%. If you look since the beginning of March, the return is over 100%. Many would be okay with earning that in almost a decade! With that in mind, some contend that it is time to take profits as the asset class is priced for perfection.
FINSUM: This is an interesting and classic debate. If performance is so stellar, should you take the victory and get out, or stick with your winner? If momentum investing has taught us anything in the last half decade, it is to stick with winners. Looking more fundamentally, small caps have historically outperformed when the economy is growing, so there should be some tailwind.
Small caps are looking strong, and seem likely to outperform large caps over the next year. Small caps have seen two decidedly positive trends over the last month—an outperformance relative to the S&P 500, and increasing breadth. From a technical perspective, those are both encouraging. On the fundamental front, small caps are starting to follow a well-trodden path to success. Historically, every period since 1990 in which the Russell 2000 has outperformed the S&P 500, spreads have been widening. Bond watchers will have noticed that Treasuries have risen 28-40 bp recently across different maturities. Since that rise in yields seems likely to continue because of the growing debt needs of the US government, small caps may be in for a good run.
FINSUM: We really like this logic. Small caps tend to have a higher beta to GDP, so rising yields (hopefully indicating a better economic environment) should create additional spread widening, and thus be positive and create some continued outperformance.
Investors are increasingly betting on a blue wave. More interestingly, the market’s calculus for what that blue wave to could mean to stock prices and the economy is changing. For much of this election cycle, a sweep by the Democrats was seen as a negative for the economy versus the status quo. However, in recent weeks investors have been shifting the other way—seeing a blue wave as a win for the economy. The reason why has to do with infrastructure spending and bigger and longer-term stimulus packages. While the possibility for this has been hurting Treasury prices because of the likely increased debt load, it also means that both infrastructure stocks and small caps seem poised to gain as we approach the election and well after it.
FINSUM: Small caps have just recently started to outperform their large cap cousins, a sign of the shift in perspective. Infrastructure stocks seem a good bet because no matter who wins the election there will probably be some deal on that front.