Opus Capital Management commentary for the month of February 2017, titled, “Quantitative Review Of U.s. Small Caps.”
Seth Klarman Tells His Investors: Central Banks Are Treating Investors Like “Foolish Children”
"Surreal doesn't even begin to describe this moment," Seth Klarman noted in his second-quarter letter to the Baupost Group investors. Commenting on the market developments over the past six months, the value investor stated that events, which would typically occur over an extended time frame, had been compressed into just a few months. He noted Read More
- The market continued to press forward in February, posting strong numbers across the board. Even though small caps performed well in February, returning 1.9%, the size segment trailed large caps and mid caps for the second straight month. U.S. large caps continued their momentum from January, returning 4.0%, now leading small caps by 3.6% for the year. After this stellar performance in large caps and upward revisions in small cap EPS estimates, small caps now only trade at a 7% premium to large caps, down from the 15% premium last month. With the Russell 2000 Index (R2K) trading at all-time highs in February, many of the constituents are now trading 20% above their 200-day moving averages, a level not seen since 2013. Historically, when this many stocks are above their 200-day moving average, subsequent performance has been below average.
- After losing by a wide margin last year to the Russell 2000 Value Index (R2KV), the Russell 2000 Growth Index (R2KG) posted its second straight month of relative outperformance. Growth beating Value was a trend across all size segments with the spread for small caps standing at 3.4% for the year. The main two factors driving this spread is the outperformance in the fastest growers and strength from biotechs. Biotechs led the charge, returning back-to-back 9% performances in January and February for R2KG. They have almost wiped out all of the losses from last year’s return in the first two months. Finally, when Value wins by such a large margin against Growth in the previous year, it tends to keep the momentum going forward into the new year, which has not been the case so far in 2017.
- After a tough 2016, Health Care has gone from worst performing sector to the first. Health Care was driven higher by performance in biotech and the increased speculation of M&A activity with larger companies looking for organic growth in a muted environment. Health Care tends to be more domestically oriented and has above average tax rates due to the service nature of business. On the opposite end, Energy, one of the best performing sectors in 2016, is now the worst performing sector thus far in 2017. Speculation that non-OPEC countries will not hold up their end of the bargain and increased drilling from the higher-cost producing shale companies, capping oil prices, are culprits.
- After seeing inflows of over $17.5B last year, small-cap ETF flows continued their momentum as we have seen inflows totaling $3.8B in 2017, outpacing last year’s inflows year-to-date. Counterintuitively, the largest market cap names have continued to outperform during this period. The biggest winner for the month was highest leverage, with non-earners and fastest growers outperforming for the year, piggybacking off of biotech’s strength. Overall, lower quality companies have led this early rally.
- Small cap active management saw a glimmer of hope in January as all three styles (Core, Growth, and Value) saw over 50% of their managers outperform their respective benchmarks. February, on the other hand, was not as kind as all three styles saw fewer than 50% of their managers outperform. Only 32.8% of managers outperformed in Value, bringing the year’s total to 53.0%. Growth has fared best with 69.2% of managers outperforming in 2017.
Many of last year’s trends reversed in January, and these recent outperformers continued their strength in February. Higher market cap, which lagged last year, performed well, even with ETF inflows totaling $3.8B this year, well above the amount from the same period last year. In 2016, the Russell 2000 Growth Index (R2KG) relatively underperformed against the Russell 2000 Value Index (R2KV) due to the fastest growers and biotechs performing poorly, both of which have performed well year-to date. On the other hand, non-earners, a leading factor last year, continued its run. Higher leverage was the best performer in February as interest rates remained relatively flat for the entire month. After an abysmal January, yielders outperformed non-yielders by 24 bps during February, but still trail on the year by over 100 bps.
With the economy improving and companies feeling better about this year’s growth propects, the earnings revision ratio, which measures the ratio of number of positive revisions to negative revisions, was above 1.0 in every sector, leading to the highest reading since 2014. Small caps are now trading at a forward multiple of 19.1x, which is 21.9% above the long-term average. At the end of January, small caps traded at a 15% valuation premium compared to large caps. With the recent relative strength in large cap performance, this valuation spread has decreased to 7%. This spread has historically been around 4%.
The R2KV’s forward P/E is no longer trading at an all-time high, but remains historically elevated at 17.9x. This is 32.6% above its historical average.
Opus Capital – Russell 2000 Value Sector Performance
Since 1945, there have been 27 years when the S&P 500 has achieved gains in both January and February. The S&P 500 finished up for the year (on a total return basis) in every one of these years, with the average rise in those years being 24%, though this number is skewed from returns earlier in the time period. Large caps have started the year strong, returning 5.9%. Historically, when U.S. large caps outperform U.S. small caps in January, large caps have won on the year. Nonetheless, both large caps and small caps had a strong February, posting returns of 4.0% and 1.9%, respectively.
After a strong rally against the R2KG in 2016, the R2KV quickly cooled, as Value has underperformed Growth by 3.4% for the year. Growth has had tailwinds that it did not experience in 2016, i.e., outperformance in the fastest growers and the market leading return of biotechs. Growth has a material overweight in biotechs versus Value’s nominal weighting, proving to be one of the main reasons for Growth’s outperformance.
In February, Health Care continued its momentum, while banks drove Financials, and Technology was boosted by earnings revisions. Energy was the worst performer during the month, and, though early, is now the worst performing sector within the R2KV for 2016, overtaking Consumer Staples.
Health Care and Energy have been a tale of two years. Health Care was the worst performing sector in the R2KV for 2016, underperforming the benchmark by almost 27%, while Energy outperformed by 12%. So far in 2017, Health Care has been leading the charge, returning 9.1%, with Energy being the worst, declining 7.9%.
After a tough year, Health Care is now leading small caps due to increased speculation of M&A as larger players look for additional ways to grow. Health Care companies tend to be domestically oriented and have a slightly higher average tax rates because of the nature of their service businesses. Energy, on the other hand, has performed poorly in 2017, even with the price of oil being flat. Investors are skeptical of the validity of the OPEC deal, which drove oil higher late in 2016, but also propelled more domestic shale producers to ramp up production, capping oil prices. Energy companies have already raised $6.2B of equity this year, which has accounted for 37% of the total equity raised this year in the market. Companies that raise a significant amount of capital in a year dilute forward earnings, and tend to perform poorly.
Active managers had a difficult showing in February after the year started off strong in January. Only 32.8% of Value managers outperformed their benchmark in the month, bringing the year-to-date total down to 53.0%. Banks drove the Financials sector, hurting managers due to their underweight in the space. Growth has fared better with 44.4% beating in February, bring their year-to-date total to 69.2%. Growth managers have benefitted from the fastest growers signficantly outperforming the slowest growers, but have been hurt by biotechs due to the material underweight they have in the industry versus the benchmark.
Opus Capital Management
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