As equity markets recover from their losses due to the pandemic’s shutdowns, one asset class in particular—small-cap value—has lagged more than other major indices in terms of its valuation. Is that a buying opportunity? Or a cautionary tale? To help us make sense of what’s happening in that space, we will talk with Garth Nisbet, Senior Portfolio Manager on the Stageline Value Equity team at Wells Fargo Asset Management.
Laurie King: I’m Laurie King and you are listening to On the Trading Desk®. This episode talks about opportunities in the stock market, focusing on small-cap value stocks. Whereas the S&P 500 Index has recovered most of its losses this year—it’s up 1% year-to-day—and the tech-focused Nasdaq Index is near all-time highs—it’s up about 20% year-to-day—small-cap stocks as measured by the Russell 2000 Index have lagged. They’re still down about 10% year-to-day. Could this be a buying opportunity? Well, to answer that, we’re talking with Garth Nisbet, Senior Portfolio Manager on the Stageline Value Equity team at Wells Fargo Asset Management. Welcome to the program, Garth.
Garth Nisbet: Thank you, Laurie. Glad to be here. Thank you for having me.
Laurie: I highlighted just a little bit of what has happened in the equity markets so far this year. Can you begin by setting the stage for our listeners of where the markets stand today? Maybe the differences between large- and small-cap and growth or momentum?
Garth: Yes, indeed. The past 12 months have been among the most volatile on record for the equity markets.
But as you noted, the second quarter was very strong. We saw a rebound that began in mid-March that contributed to a very favorable second quarter. The rally gained momentum, notwithstanding the many challenges on Main Street, on the premise that control the coronavirus might be within reach in 2020 or early 2021.
The S&P Index finished the quarter up over 20%, the Russell 2000 Index of small-cap stocks rose over 25%, and biotechnology and pharmaceuticals performed well, as many companies worked towards a coronavirus vaccine. Yet small-cap value lagged relatively in the second quarter, up 18.9%.
The second quarter was also unusual to some degree. The most profitable companies were generally out of favor, and stock performance was inversely correlated to return on equity of those companies. Year-to-date through July 22, the Russell 1000 Large-Cap Index is actually positive at +3% while the index’s small-cap stocks, the Russell 2000, is down 10%, as you noted. Small-cap value has, in fact, lagged and is down 21.6% year-to-date.
So Laurie, let me touch on the differences between small-cap and large-cap, as well as value and growth.
Large-cap stocks are typically over $10 billion and, of course, the mega-cap stocks—the Apples, the Amazons—are $1.5 to $1.6 trillion. Small-cap stocks, on the other hand, are typically between $100 million and $5 billion. The median for the benchmark is approximately $2 billion. So small-cap versus large-cap, a very big difference in market cap, a big difference in terms of risk management, philosophy and process, and portfolio construction.
Value versus growth, the Russell Investment Group uses three primary metrics to distinguish growth versus value: price-to-book, forward earnings estimates, and trailing five-year sales. Those three metrics really create the DNA for every stock. And stocks that have relatively high trailing sales growth, relatively high earnings growth, relatively high price-to-book, those stocks would typically be in the growth benchmark. Likewise, stocks with relatively low price-to-book, relatively low trailing sales growth would typically be assigned to the value benchmark.
Laurie: Thank you so much for really explaining what value is and also sharing what’s been going on in that corner of the market. Now why invest in this less-loved, less glamorous corner of the equity market, namely small-cap value?
Garth: It’s really a philosophical issue, in our view, that investing is not unlike decisions that you make for a home, for real estate. You really want to typically find attractive values, right?
So in our view, value investing has been, long-term, a very successful philosophy and strategy for investing. In fact, a number of analysts have looked at the long-term results of various styles of value versus growth and value versus the broad market. And consistently over the long-term, value has outperformed and small-cap has outperformed.
The most recent series goes back 94 years, and what we find is that for any 20-year series since 1994, the small-cap value market has never underperformed the broader market, and it’s achieved a median annualized outperformance of 5.4%.
The 10-year series has been clearly more volatile, but even that series, the median outperformance is roughly 6% over the full period.
And today, one of the reasons why we think this is so attractive is that the lag on the 10-year basis has never been as extreme as it is today at -7%. So we view this as an opportunity, perhaps once in a generation—clearly, once a decade—opportunity.
Small stocks tend to typically outperform as the markets recover, as the economies recover, and typically outperform really nicely after significant market drawdowns.
So we encourage investors to look forward. We know the rearview mirror has been particularly challenged for small-cap and small-cap value, but going forward, experience is just that forward returns, in our view, should be very favorable.
Laurie: It sounds like an investor’s time frame is very important for allocating to this asset class. Is that more true for small-cap value than other equity asset classes? And would an investor need to invest at the very bottom of the trough in prices to be rewarded?
Garth: Well, that’s a great question. I recall when I first started in the business in the 1980s, there was a famous chart, the Ibbotson Associates Chart, that went back to 1926. And what they found is they compared small company stocks, large-company stocks, government bonds, treasury bills and inflation, and they calculated long-term results in annualized returns, and what you saw in this chart was that at the top was small-cap, right? As a young analyst, that was ingrained in our mind.
My point is that I don’t think this is an absolute that you have to buy today, but the benefit of buying today is that you have a combination of long-term benefit, as well as you’re following a very significant drawdown.
So in that respect, in this paper, quantitatively we looked at the results of an investor after a particular market downturn, after a drawdown. We looked at the 25 most challenging quarters over the past 94 years and, hypothetically, what would your five-year return, going forward, look like as you invested after a downturn?
And really you don’t have to catch the bottom, if you will. You can miss it by a quarter, by two quarters, by three quarters, or even a year, and you still have returns for small-cap value that are in excess of 20% based upon the five-year annualized returns. So it’s obviously not a guarantee. We can’t guarantee forward performance, but based upon historical results, the odds appear to be favorable, in our opinion.
Laurie: Those are certainly interesting historical results. What did your research show you about investing in different style categories?
Garth: Well, that’s also a really rich database and is probably one of the most discussed areas in investment research, what they call the Small-Cap Value Anomaly, which is researchers can’t really explain the risk-adjusted favorable returns for small-cap value. So it’s one that we find very compelling. We think there’re a number of reasons to favor small-cap value, and particularly today, when you have relative returns quite attractive for small-cap value relative to alternatives.
So in our paper, we really outline a number of valuation ratios, such as price-to-sales, price-to-earnings, price-to-book, and then we compared the price-to-book of small-cap value versus the price-to-book of small-cap growth. And what you see today is you have an all-time high between the valuations for small-cap growth and small-cap value. It’s literally a 20-year longest record we can identify for the ratio of the price-to-book. And it’s similar to other ratios, price-to-earnings, price-to-sales, etc.
And so the last time we saw this high was in 2015. We had a high of the ratio was about 3.2 and at that time it was an all-time high, but as we mentioned, today it’s even higher. Really closer to four times. And in our view, the biggest lift recently has been due to the pandemic, as everyone’s working from home and really pushing their technology on a day-to-day basis.
Laurie: Well, let me follow up on that then. Small-cap companies, the mom-and-pops, are seen as particularly vulnerable to the coronavirus shutdowns. I’m curious how you are factoring in the Paycheck Protection Plan stimulus and the many unknowns about the economy into your day-to-day investing?
Garth: Yes, our core philosophy is to pursue small-cap companies, those mom-and-pops, if you will. That’s our passion. That’s where we are most excited is to find those quality companies that have been temporarily disadvantaged, based upon the current pandemic, but we’re able to buy them at discounts.
In many ways, Wall Street loves to complicate things. But yet once you simplify it, once you peel away the onion, at the core you have an entrepreneur, right? And she is trying to design, to build, and sell a product. So Wall Street can either provide debt financing or equity financing. That’s it.
On a diversified basis, our team participates in equity financing through highly selective, long-only public equity investing. In our view, it’s the most direct way to participate in some of the most exciting and entrepreneurial companies in the United States, those mom-and-pop companies, if you will.
Certain investment styles within the equity markets offer better opportunities for active managers to demonstrate their skill. This is important, in our view, as we think about distinctions in active management, because small-cap investing tends to be a bit more opaque. There’s an information race, if you will. Small-cap companies tend to be less followed by Wall Street, so more opportunity for pricing imperfection, more opportunity for overreaction in the stock market.
Laurie: And finally, what did your research have to say about asset allocation to the small-cap value class?
Garth: Well, it’s interesting. A number of analysts have come on, really since May, and start to advocate for rotation for rebalancing for a pivot to value, a pivot to cyclicals, energy, financials. We haven’t heard that in a long time. And timing is difficult. These moves can be glacial, and in today’s world, we want something in the next 15 seconds. These growth-to-value rotations can take quarters and even years, but in our view, now is an excellent time to begin to pivot your portfolio to value into small-cap.
Laurie: Garth, thank you so much for joining us and sharing your insights about the small-cap value area.
Garth: Thank you so much for having me today.
Laurie: For our listeners, if you’d like to learn more about investing, go to wellsfargoassetmanagement.com. Until next time, I’m Laurie King; take care.