- U.S. small caps continued to press forward in April as every month thus far in 2017 has yielded a positive return. Small caps returned 1.1% during the period, in line with U.S. large caps for the second straight month. Large caps, boosted by outsized relative performance in January and February, have doubled up small caps’ return for the year, outperforming by 3.6%. With large caps beating small caps by a wide margin this year, small caps only trade at a 7% premium to large caps, almost in parity with the average premium of 4%. For reference, at the end of January, small caps traded at a 15% valuation premium to large caps. The Russell 2000 Index (R2K) once again crossed the one-standard deviation line, trading at a forward P/E of 19.1x. The Russell 2000 Value Index (R2KV) and the Russell 2000 Growth Index (R2KG) trade at 17.8x and 21.1x, respectively.
- Growth has outperformed Value by more than 1.0% in each of the first four months of the year, while last year, Growth only outperformed Value in a total of three different months. This year, Growth leads by a staggering 7.0% against Value, driven by the performance of the fastest EPS growers and the YTD strength from biotechs. Biotechs did not have a material impact on performance this month, but have returned 17.2% for the year. From a sector perspective, Value’s overweight in Energy and underweight in Health Care are to blame for the relative underperformance. 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.
- The month of April saw a resurgence from bond proxies, with REITs and Utilities outperforming on the back of falling rates and the fear of weakening Q1 GDP number. Energy continued to fall during the month, returning -9.4% in the R2KV. Energy remains the worst performing sector for the year, down 19.2%, due to the Saudis losing control of OPEC and oversupply in the United States due to higher-cost producing shale companies increasing production. Health Care continued to perform well in the month, even without the support of biotechs, with increased speculation of M&A activity with larger companies looking for inorganic growth in a muted environment. Health Care continues to be the outsized winner for the year.
- For the first time since October 2016, high quality was the clear winner for the month of April. Up until the end of the first quarter, non-earners, outperformed companies who made money. This trend significantly reversed this past month, as non-earners fell almost 3%, and now trail year-to-date versus earners. Higher-quality companies benefited from lower leverage, yield, and higher ROE. Lower market cap, which tends to be grouped as a low quality factor, was the only metric that performed well for low quality. Lower market cap was a benefactor from the continued ETF inflows that occurred during the month.
- Year-to-date, 32.9% of small cap core managers are outperforming their relative benchmarks. Value and Growth managers have fared better with 59.9% and 60.1% outperforming, respectively.
Review Of U.S. Small Cap Value
For the first time since October 2016, higher-quality factors were the clear winner during the month of April. This was quite a reversal as the first quarter favored lower-quality factors. April yielded such a turnaround in these factors that many high-quality metrics now lead for the year. The biggest reversal was the weakness for companies which do not make money, non-earners. During the first quarter, non-earners were bolstered by biotechs, but this wasn’t the case for April, as biotechs were flat for the month. Energy companies, which also tend to not earn money, were the culprit, dropping 9.4%.
High quality outperforming tends to bode well for active management, but that wasn’t the case for April. Value managers fared best, with 53.5% of managers outperforming their benchmark, while only 38.7% of core managers outperformed. Though this month favored higher quality, sector positioning detracted from managers’ performance. Managers have been overweight in Energy, which significantly contributed to underperformance, as the sector dropped nearly 10% in the month. Furthermore, managers are actively underweight bond proxies, which led performance this past month.
Small caps are now trading at a forward multiple of 19.1x, which ranks in the 98th percentile on an absolute basis. On a relative basis, small caps do not look as expensive versus large as they trade only at a 7% premium. Since 1979, the average premium has been 4% between small and large. The R2KV’s forward P/E remains historically elevated at 17.8x, while Growth trades at 21.1x.
Russell 2000 Value Sector Performance
U.S. large caps have started the year strong, returning 7.2%, doubling the return of U.S. small caps. Small caps have kept pace with large caps over the last two months, but relative performance in January and February is the reason for the YTD relative underperformance. Interestingly, when small lags large in Q1 and is more expensive than large, as we saw during the first quarter this year, small tends to catch up in the following nine months, ending the year even with large.
April saw interest rates decrease with increased speculation of a weakening Q1 GDP number as economic data has been generally weaker than expected. Volatility, which has already been at historically low levels, continued to drop as the French released exit poll data showing Macron with a significant lead over the far-right candidate, Le Pen. Volatility may pick up in the future, which bodes well for active management, as U.S. politics continue to heat up with legislation reform and a potential surprise victory for Le Pen, which will lead to increasing speculation of a Frexit.
A recurring theme for 2017 has been the R2KG outperforming the R2KV, which was the case in April, as Growth beat Value by 1.5%. The active underweight in Energy and Financials led to Growth’s victory during the month. After the strong rally against the R2KG in 2016, the R2KV quickly cooled as Value has underperformed Growth by 7.0% for the year. Growth has 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 April, Health Care continued to press forward without the help of biotechs, whose return was in line with the market’s return. The surprise in April was the return of bond proxies, i.e., REITs and Utilities, both of which benefited performance with the decrease in interest rates. Consumer Discretionary, which started the year poorly as negative sentiment surrounded the retail industry and reports of store front overcapacity surfaced, outperformed in March and April. Contrary to last year, Energy continued its slide, declining 9.4% during the month, now down 19.2% on the year!
Health Care and Energy have been a tale of two years. Health Care was the