Over the past several months, the coronavirus pandemic has weakened the global economy, wreaking havoc on markets around the globe. While most asset classes were not impervious to the laconic drawdowns in the first quarter of 2020, small-cap stocks were hit particularly hard. The Russell 2000® Index, composed of small-cap stocks, set a record for the quickest descent into bear-market territory, taking only 12 trading sessions to drop 20% from its February peak.
During its peak-to-trough decline from February 19 through March 18, the Russell 2000 Index fell 41% while the large-cap S&P 500 Index declined by 35% over roughly the same period. The RVX, a measure of the implied volatility of the Russell 2000 Index, surged to a multiyear high of 83%—its highest level since 2008.
Although the speed and amplitude of this recent sell-off were both alarming and elevated relative to history, bear markets are not rare. In fact, since 1962, small-cap investors have experienced a 20% correction roughly every 6 years, on average.
Small-cap stocks are typically regarded as more risky relative to large-cap stocks. Their business models generally are more nascent and are often tied to a single product or service, making them more susceptible to the economic cycle. Because their future cash flows can be more at risk if the economy falters, small-cap companies typically underperform their large-cap counterparts during bear markets and recessionary periods.
Leverage and liquidity are key reasons this tends to be the case. Small-cap stocks generally have higher leverage, lower profitability, and overall lower credit quality —factors that become exposed as credit spreads widen amid periods of market turmoil. As investors tilt their portfolios toward companies with higher-quality balance sheets, small-cap stocks often bear the brunt of having weaker balance sheets.
Lack of liquidity also exacerbates small-cap underperformance during risk-off periods. The same size variable that can serve as additional compensation in the form of an illiquidity risk premium for the small-cap investor is often the same factor that investors lament during periods of stress. As selling pressure increases during periods of risk aversion, smaller, less liquid stocks experience more downside volatility due to trading frictions.
As the relative outperformance of large-cap stocks persists, the invariable question is whether small-cap stocks are destined to catch up. The answer is largely predicated on positive changes to economic fundamentals. As key pillars of the economy recover, like unemployment and consumer spending, a positive change in demand can enable small caps to capture the economic improvement more rapidly than large caps.
This is partly due to the dexterity of small-cap business models. They tend to be able to quickly align a sales force or ramp up production to meet increased demand. Also, marginal revenue improvements can have a larger proportional impact on a small company’s financial statement than a larger company’s. Lastly, valuations are very supportive: Small-cap stocks are trading at their lowest levels in 15 years relative to large caps.
The main factors that led to small caps’ relative underperformance during the downturn earlier this year may be the same ones that could help bolster their performance as the economy improves and investors become more comfortable with more leverage and less liquidity.
Historically, we’ve seen significant recoveries within small-cap stocks when the economy rebounds. For instance, coming out of recessions, small caps have outperformed large caps in the past 9 out of 10 economic downturns. Moreover, in the six months following each of the past 10 bear markets, small caps have delivered a staggering 37% return, on average.
Within the small-cap universe, we believe the best opportunities exist in companies with disruptive business models that can generate secular growth and compound sustainable growth over extended periods. This recent coronavirus period has pulled forward several secular trends that have become indelible to many people. Some of these trends are evident within areas we’ve been discussing for the past few years: software as a service (SaaS), cloud services, online retail, digital payments, the internet of things, and innovation—which we refer to by the acronym SCODIi.
Within SaaS, companies offering critical event-management capabilities are helping people function through multiple verticals within the work environment. In cloud computing, workload usage has spiked at the enterprise and individual levels as more people vie for storage and bandwidth. Although consumer spending has decelerated overall, online shopping has risen sharply, boosting e-commerce traffic and enabling payment processors and merchant acquirers to benefit from increased digital transactions. Also, digital education via online learning platforms has become ubiquitous throughout the crisis. The internet of things within the semiconductor industry has played an essential role as cloud services usage from areas like gaming have driven demand for more powerful chip hardware. Lastly, within innovation, diagnostics companies have changed their testing methods by setting up mobile stations for patients who would otherwise be unable to receive needed services. We believe these are the types of small-cap companies likely to flourish as the economy recovers.
Small caps’ prolonged underperformance over the past several years could be partly because they’re more leveraged to the economic cycle and economic growth has been tepid since the financial crisis. Factoring in the sharp drawdown in February and March along with the market strength in April and May, the underperformance of small caps has become even more exacerbated this year. As of May 31, 2020, the Russell 2000 Index had fallen nearly 16% compared with the S&P 500 Index, which had fallen roughly 5%.
Nevertheless, even if we factor in 2020’s underperformance, the size premium for small caps has proven to be a worthy risk/reward proposition for investors who have the discipline to maintain a long-term time horizon.
The Russell 2000® Index measures the performance of the 2,000 smallest companies in the Russell 3000® Index, which represents approximately 8% of the total market capitalization of the Russell 3000 Index. You cannot invest directly in an index.
The S&P 500 Index consists of 500 stocks chosen for market size, liquidity, and industry group representation. It is a market-value-weighted index with each stock’s weight in the index proportionate to its market value. You cannot invest directly in an index.
The Ibbotson Associates Stocks, Bonds, Bills, and Inflation (IA SBBI) U.S. Small Cap Index is a capitalization-weighted index designed to measure the performance of the smallest 20 percent of publicly listed equities as ranked by market capitalization. You cannot invest directly in an index.
The Ibbotson Associates Stocks, Bonds, Bills, and Inflation (IA SBBI) U.S. Large Cap index is a capitalization-weighted index designed to measure the performance of the largest 20 percent of publicly listed equities as ranked by market capitalization. You cannot invest directly in an index.
Doug Basile is a Senior Portfolio Specialist with the Heritage Growth Equity team at Wells Fargo Asset Management.