Eq: Small Caps
Small caps have been sluggish since Q2 2022 most indicated by the poorer returns in the Russell 2000 and S&P 600 Small Cap. However, things could turn around for the smaller companies moving forward. A value tilt is pervasive through many small cap companies and as the yield curve begins to steepen that value tilt will edge out over larger growth companies. The other factor favoring small caps is the pending corporate tax minimum. Only 1 of the S&P 600 small caps will see their liabilities rise but lots of S&P 500 companies will face new tax burdens which they previously avoided. This is a historic opportunity for small caps moving into 2022.
FINSUM: With Powell’s renomination it's more likely the yield curve will steepen as future rate hikes will be priced in but no real indication of a move currently; increasing the likelihood of a small cap comeback.
Bank of America put out a very refreshing outlook today, reminding investors of an asset that has traditionally thrived in times of high inflation. And no, it isn’t gold or other commodities. That asset is…small caps. BAML says that small caps, and value stocks as well, have traditionally performed well in high inflation environments, such as in the 1960s. According to the firm, “Our US Regime Indicator has shifted to Mid-Cycle, a phase where inflation is typically strongest. In this phase, small caps and Value have typically outperformed large caps and Growth - further supported by the profits recovery and economic rebound we expect this year. Small caps and Value stocks were also some of the best-performing assets during the inflationary period of the late 60s”.
FINSUM: History aside, we cannot really agree about the idea that small caps will thrive. Relative to large caps, small caps have a higher employment cost base because their employees are more often in the US. Their supply chains are more domestic too. That means all their costs will rise alongside their revenue. Take a larger multinational—Apple for example—most of its manufacturing and supply chain costs are offshore, which means it can enjoy rising inflation-driven revenue, but take advantage of lower inflation rates in its cost base.
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.