Eq: Small Caps
Small caps are in a major rut. The Russell 2000 peaked in August and is now on the verge of a bear market since then. Interestingly, small caps have fallen farther than their larger peers despite the fact that they are insulated from headwinds like the trade war. So how to pick them? The answer is to stay away from indexes and actually choose individual shares whose fundamental outlooks appear brighter than benchmarks. For instance, one fund manager says that investors should choose “quality value stocks” with “with high free-cash-flow yield, low net debt to earnings before interest, taxes, depreciation, and amortization, or Ebitda, and below-market volatility”.
FINSUM: Small caps are a hugely diverse sector and some shares will inevitably have bright outlooks no matter what else may be going on in the market. The issue, of course, is the time and selection necessary to find such shares. Perhaps actively managed small cap value funds are a good bet?
Investors looking for signs of trouble have no shortage to examine. However, one that might have escaped notice is that small caps are on the brink of a full blown bear market. The Russell 2000 has fallen a whopping 17% since its all-time high close on August 31st. The S&P 500, for comparison, is off 10%.
FINSUM: This is really interesting because it doesn’t make much sense. Both the trade war and the economic situation are more favorable to small caps than their larger peers, yet they are falling more sharply.
One of the guiding mantras of small cap investing has always been that small caps tend to outperform their larger peers over the long-term. While always cyclical, small caps have outperformed large caps over the last several decades. However, in recent years that has all changed. In fact, since 2005, the relative performance between the two share classes has been trendless, with no discernible relationship. This is directly counter to the almost century-long trend that preceded it. One CIO explained the change this way, saying “Market-cap tilts have historically been about catching, and riding, strong and persistent performance waves … Over the last 13 years, in an unconventional fashion, the opportunities to add performance from cap tilts have been relatively small and have required frequent and expert timing”.
FINSUM: Interesting change for small caps. We suspect the change has to do with a combination of the pre-Crisis boom and the extraordinary liquidity thereafter.
One of the big beneficiaries of all the geopolitical events of this year, as well as of rates hikes, has been small caps. Smaller companies tend to perform better in economic expansion, and they look more likely to hold up to foreign trade tensions as they have a more domestic focus. After hitting records in August, small caps are now in correction territory, having lost 10% from their high. They are now underperforming large caps for the first time this year as many see trade tensions easing.
FINSUM: Small caps sometimes suffer at the end of economic expansions, so this move makes sense. Still an almost 9% loss in the Russell 2000 this month is rough.
Small cap stocks have been taking it on the chin. They have been getting hammered this week, and their performance (Russell 2000) has lagged the S&P 500 by almost 3% the last few days. That is a rare occurrence, which means there may be a buying opportunity. After such a bout of bad performance, the Russell 2000 has historically outperformed the S&P 500 by a percentage point over the next 20 days.
FINSUM: This could be a good short-term buying opportunity, but as ever, we struggle with these kinds of trade ideas because they seem to be based purely on historical precedent and lack any catalyst.