Things started to change in the fourth quarter of 2020 (Display above, right). As news of COVID-19 vaccine successes raised hopes of a broader economic recovery in 2021, investors started to move back into stocks that are considered more sensitive to the economic cycle. As a result, US small-cap value stocks advanced by 33% in the fourth quarter, outperforming growth stocks and the broader market.
Is the Small-Cap Value Rally Over?
After such a sharp recovery, have investors missed the opportunity? We don’t think so. By understanding why small-cap stocks underperformed over the past four years and what’s changed, we believe investors can gain confidence in the recovery potential. Since the small-cap slump of recent years was so dramatic, the late 2020 rebound has only recovered a small amount of the underperformance. And there are good reasons to expect smaller, attractively valued companies to do well as the macroeconomic recovery progresses this year.
Growth companies outperformed over the last four years as the challenging economic climate made earnings growth exceptionally scarce. Low interest rates also helped growth companies, which tend to generate cash flows in the more distant future and benefit as lower discount rates make the valuation of those cash-flow streams more attractive today.
Even the uncertainty of the pandemic led investors to continue flocking to larger, growth-oriented companies for their perceived safety. But risk appetites seem to be changing with the improving economic climate, and we believe investors are just beginning to reward smaller value stocks with solid businesses showing real earnings power.
Earnings power helps explain the recovery of small-cap value stocks in late 2020. Earlier in the year, investors shunned these stocks amid fears that they were more vulnerable to the pandemic’s consequences. In fact, many navigated the crisis better than expected. Sales and earnings in many of these companies recovered more quickly than expected after the initial pandemic shutdown panic abated.
Smaller Businesses Adapted Well to COVID-19
For example, as shutdowns began in April, it was feared that small-cap banks’ provisions for bad debts would overwhelm their earnings and perhaps even force them to raise equity. Yet six months later, many of those banks were beating quarterly earnings expectations on lower-than-expected loan losses.
Small value companies have also been more flexible and adaptable to the recessionary environment than expected. Of course, some industries such as restaurants and airlines have faced intense pressure. But in general revenues and profits for consumer cyclicals and industrials, among others, have bounced back better than expected, even though investors gave them no credit for potential resilience during the downturn.
And even with fourth quarter’s beginning of a bounce back, small value stocks are still as cheap as they have been since the height of the tech bubble 20 years ago (Display).
