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US small caps set for ‘several years of dominance’

US small caps set for ‘several years of dominance’

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This article was originally published by BNP Paribas Asset Managment Blog ( Investor's Corner)

US small capitalisation stocks have had a rough ride, and not just because of the COVID-19 induced economic downturn. But they could now be set to expand their lead on large caps, Pamela Woo, head of US equities, argues in this interview.  

How have US small caps performed over the last cycle and since the pandemic?

The most recent cycle began in 2013 and, leading up to the COVID-19 pandemic, US small caps had underperformed significantly. The outperformance of the S&P500 versus the Russell 2000 small cap index was a cumulative 55%, or more than 8% annualised. I must say such extremes in performance are rare: The last time we saw something similar was in the lead-up to the dotcom bubble of the late 1990s.

One reason that the small cap index fell by more than large caps going into the pandemic is that it contains industries facing long-running challenges such as retail, travel & leisure, energy and real estate investment trusts (REITs). These account for roughly 25% of the earnings of all 2 000 index companies. That is almost double that of the S&P. We do expect this to be offset by de-globalisation or the reshoring of US manufacturing however, benefiting those small caps with a higher domestic exposure.

“De-globalisation and reshoring should benefit domestically oriented small caps”

Since late March, US equity markets have recovered, propelled by the rapid response of governments globally to the crisis. Now, the Russell 2000 is 56% above its March lows, ahead of the S&P500, which has risen by 40% since then. Ultimately, we believe a vaccine and the recent cyclical reversal could result in several years of small cap dominance. 

Which sectors and industries have done well in the first half of the year?

Rather than size or scale, what has had the largest impact on corporate earnings has been the industries in which companies operate. Firms involved in vaccine development, telehealth and diagnostic testing, remote connectivity, ecommerce, digital streaming, etc. have all benefited considerably. In many cases, the pandemic has accelerated their disruption of more classic business models. 

While at end-July, reported second-quarter profits[1] were down by 55%, this was ahead of the consensus forecast. Over 75% of companies that had reported had beaten analyst estimates. Overall, this is an encouraging sign for small caps. However, it must be said that more than 40% of small cap companies are unprofitable. That is the most since 2010. 

“Small cap results have been encouraging”

How does that fit the rise in the Russell 2000? Monetary and fiscal support is indeed having a meaningful impact. Markets have been keenly aware of this ‘protection’. Shares in some of the most battered corporates have seen impressive rebounds since the March lows. However, this concerns mainly much smaller capitalisations. In most cases, prices are well below previous highs. 

The next move higher will not be so easy. We believe it is of increasing importance to allocate to businesses that will return to profitability, benefiting from sustainable competitive advantages rather than government lifelines.  

What is the outlook for US small caps?

Our scenario calls for a deep recession in the first half, with earnings hitting a low in the second quarter, followed by a gradual, but bumpy recovery. Markets may remain choppy in line with the news on economic indicators and the lingering coronavirus.

We believe the highly proactive policies to kick-start consumption and support companies point to a favourable trend for risky assets in the medium term. Investors will have to assess whether the damage to the economy is temporary or permanent. At this point, the macroeconomic backdrop has brightened: 1) the PMI purchasing managers’ index has improved; 2) a weaker US dollar usually helps small caps more than large caps; and 3) risk premiums on high-yield bonds have dropped.

“Proactive stimulus points to a favourable trend for risky assets”

However, we need to be watchful. Rising COVID-19 cases may undermine the recovery and market sentiment. We would like to see further improvement in data across consumer industries, including restaurants, retailers and hospitality, and in retail sales and PMI data.

Ultimately, the development and distribution of a vaccine may be critical in restoring confidence and economic activity to pre-crisis levels.

Are valuations attractive at this point? Which sectors and industries do you see as recovery plays?

With near-term earnings hard to forecast, it is useful to compare valuations between segments. In fact, small caps are at their cheapest relative to large caps since 2003. They are now in the 14th percentile. This has historically led to stronger relative performance over the next 3-12 months.  

“Small caps are at their cheapest in 17 years”

As the economy re-opens, we expect select cyclical sectors to continue to do well. Unloved cyclicals such as industrials, machinery, travel & leisure and restaurants may offer an attractive risk-reward profile. Medical technology firms may be winners. Biotechnology is a secular theme that we like. 

Will the outcome of the presidential election in November have an impact on US small caps?

There are different scenarios, but betting agencies forecast a victory by the Democratic candidate, Joe Biden, and the Democrats winning Congress. Although Biden’s agenda calls for higher corporate and income taxes, we believe this may take a backseat in the context of a struggling economy. Issues such as stimulus to fight COVID-19, racial inequality and China trade policies will likely play larger roles. 

“Small caps have historically generated better average gains than large caps in the final five months before a presidential election”

So far, expectations are that technology, consumer discretionary, communication services and healthcare – defensive sectors – stand to benefit from a Biden victory, while cyclical value sectors do not. It is worth noting that US small caps have historically generated better average gains than large caps in the final five months before a presidential election: 5.4% against 3.4%. 

In view of the uncertainty, we favour secular growth sectors such as tech and healthcare, and sectors that have an economic sensitivity such as industrials and select cyclicals.

Any views expressed here are those of the author as of the date of publication, are based on available information, and are subject to change without notice. Individual portfolio management teams may hold different views and may take different investment decisions for different clients. This document does not constitute investment advice.

The value of investments and the income they generate may go down as well as up and it is possible that investors will not recover their initial outlay. Past performance is no guarantee for future returns.

Investing in emerging markets, or specialised or restricted sectors is likely to be subject to a higher-than-average volatility due to a high degree of concentration, greater uncertainty because less information is available, there is less liquidity or due to greater sensitivity to changes in market conditions (social, political and economic conditions).

Some emerging markets offer less security than the majority of international developed markets. For this reason, services for portfolio transactions, liquidation and conservation on behalf of funds invested in emerging markets may carry greater risk.

[1] Also read Company earnings – There is room for upside, but mind the risks

Writen by Investors’ Corner Team. The post US small caps set for ‘several years of dominance’ appeared first on Investors’ Corner – The official blog of BNP Paribas Asset Management.

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