US Recovery Reveals Hidden Value in Smaller Stocks

Past performance does not guarantee future results.
As of December 31, 2020
Source: FTSE Russell and AllianceBernstein (AB)

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).

Past performance does not guarantee future results.
Through December 31, 2020
*Valuation composite is one-third price/forward earnings, one-third price/sales and one-third price/cash flow.
Based on Russell 2000 Value and Russell 2000 Growth Indices.
Source: FactSet, FTSE Russell and AllianceBernstein (AB)

Overcoming the Sum of All Fears

What will it take for small-cap value stocks to close the performance gap? An improvement in risk appetite is key—and the outlook is encouraging. In 2020, investors were mostly concerned about policy risk from the presidential election, the pandemic and the impact of the ensuing recession on corporate profits. All of these are now starting to recede. COVID-19 vaccines are being distributed globally. And company earnings appear to be bouncing back from the worst of the recession. While the year ahead will face many challenges, 2021 is looking like a much better year for humanity and stocks alike.

Even in an improved environment, small-cap value investors must be disciplined and selective. In value, investors seek stocks that have underperformed due to a controversy that creates uncertainty about the sustainability and value of a company’s cash flows—such as a pandemic. The challenge is to correctly identify which companies have been unfairly punished and can eventually show strong and sustainable cash flows, and then determine when to get in position.

For over 25 years through 2016, smaller-cap stocks with attractive price-to-free-cash-flow multiples in the top quartile outperformed the rest of the small-cap market by over 10% per year. But in the last four years, stock prices haven’t followed cash flow, and multiples have contracted for smaller-cap stocks. We believe this is an irrational market reaction that will eventually correct, especially as company fundamentals have continued to improve during this period of underperformance.

Compelling Catalysts for Recovery

In smaller-cap value stocks, we think a combination of strong fundamentals and compelling catalysts spells opportunity. Attractive valuation, based on metrics such as the free cash flow a company generates, is only part of the story—it’s just as important to look deeper into the fundamental story of each company to understand its competitive landscape, business environment and management capabilities. Then, investors should identify a catalyst such as a management change, stock buyback or other improvements that can drive a reassessment of the valuation of the company.

On all these fronts, the journey out of the pandemic will require heightened scrutiny. In many industries, the business environment has been permanently changed and earnings guidance is muddled at best. Investors who develop insightful, independent forecasts can gain an edge on a company’s recovery path.

As the extreme risks of 2020 recede and normalization begins, we think it’s not too late to reassess equity allocations. For investors with appropriate risk appetites, we think increasing exposure to small-cap value stocks can provide access to pent-up recovery potential in an asset class that should thrive as economies heal from the pandemic.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams and are subject to revision over time.

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Investment involves risk. The information contained here reflects the views of AllianceBernstein L.P. or its affiliates and sources it believes are reliable as of the date of this publication. AllianceBernstein L.P. makes no representations or warranties concerning the accuracy of any data. There is no guarantee that any projection, forecast or opinion in this material will be realized. Past performance does not guarantee future results. The views expressed here may change at any time after the date of this publication. This article is for informational purposes only and does not constitute investment advice. AllianceBernstein L.P. does not provide tax, legal or accounting advice. It does not take an investor's personal investment objectives or financial situation into account; investors should discuss their individual circumstances with appropriate professionals before making any decisions. This information should not be construed as sales or marketing material or an offer of solicitation for the purchase or sale of, any financial instrument, product or service sponsored by AllianceBernstein or its affiliates. This presentation is issued by AllianceBernstein Hong Kong Limited (聯博香港有限公司) and has not been reviewed by the Securities and Futures Commission