Co-CIO Francis Gannon on a September Shift for small-caps (and interest rates) and why it could mean good news for cyclical stocks.
The Small-Cap Story: Growth and Defensives Stayed Strong—Until the End of 3Q17
The Russell 2000 Growth Index climbed 6.2% versus 5.1% for the Russell 2000 Value Index—with the 5.7% gain for the Russell 2000 Index masking the strong move for value late in the quarter. Similarly, defensive sectors—with their top performer Health Care still led by biotechnology stocks so far in 2017—outpaced their cyclical counterparts in 3Q17.
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A key insight emerged when we examined the intersection of style and sector results. As the heat map with YTD results through 9/30/17 shows, the disparity between cyclical and defensive sector returns was especially pronounced within the two small-cap style indexes.
Many small-cap investors may not be aware of the considerable gap between cyclical value stocks and defensive growth stocks. We think that this gap may be closing. As small-cap specialists, we think this is the most interesting current story for the asset class.
Was There a Small-Cap Shift in September?
The idea that this performance gap may be closing is also consistent with a related, and very intriguing, development that began early last month.
From 9/7/17-9/30/17, small-cap value convincingly beat growth, cyclicals outperformed defensives, and small-cap nosed ahead of large-cap. In fact, looking at the returns for value and growth over three periods during the last year shows what we think are fascinating contrasts. (See chart)
At this same time, and not coincidentally, the 10-year Treasury yield rebounded off its YTD low of 2.05% on September 7th, climbing through the end of the month. We have previously discussed our view that many investors do not appreciate the duration senstivity of growth stocks, and this latest move provided another reminder. More important, this may indicate a longer-term move toward higher rates, which has broader implications for asset allocators beyond small-cap investing.
As for the implications for small-caps, we believe that this shift may mark a resumption in leadership for those areas that led in 2016—small-cap, value, and cyclicals—before they began to lag in 2017.
Divergent Sectors, Active Opportunities
We often find that important insights risk being overlooked unless aggregate asset class returns are more closely parsed. For example, some insist that stocks are about to experience an imminent decline without understanding that we have already experienced significant downturns via rolling sector and industry corrections over the last few years.
Healthcare corrected in 2016 while banks, energy, and many consumer staples stocks have been doing the same YTD in 2017. Meanwhile, retail stocks have been struggling over much of the last three years.
This pattern of rolling corrections can be seen as a consolidation phase, which has often been followed by renewed advance for the declining group.
If this pattern were to persist, it would continue to create potential buying opportunities for disciplined, valuation-sensitive stock pickers such as ourselves.
Are Defensives Disconnected?
With growth’s leadership still in place nearly three-quarters of the way through 2017, we are beginning to see the current U.S. stock market as disconnected from what’s happening both in our companies and the economy.
Stock and bond investors alike appear to be pessimistic. The yield on the 10-year Treasury was tumbling into early September, which typically (though not always) is a sign of concern about economic growth, just as equity investors’ preferences for higher yield and other non-cyclical investments is evidence of caution.
Of course, valuations are historically high for many stocks across the market cap and small-cap style spectrums. However, high valuations are not evenly spread, which you can see by looking at the average of EV/EBIT for the Russell 2000 Index by separating the metric into cyclical and defensive sectors.
The average valuation for cyclicals is more attractive than the average valuation for defensives—which are significantly higher.
Also worth noting are the pockets of opportunity that currently exist in the small-cap universe. Of the stocks in the Russell 2000, 712 were down YTD through 9/30/17. To be sure, not all of these would make attractive investments—but some undoubtedly are, and we’ve been looking carefully.
1 Last twelve months enterprise value/earnings before interest and taxes excluding negative EBIT
Why Go Global With Small-Cap?
Equally important is the improving global economic picture. Japan recently reported continued growth lifted by consumer and CAPEX spending; the eurozone (unresolved Brexit issues notwithstanding) continues to show encouraging PMI growth, and China’s strengthening currency is another in a series of signs that its economy is stabilizing.
Also notable is the reach of the expansion—each of the 35 countries in the OECD has positive GDP, and 65% of them are expanding.
What does this mean for small-caps? In contrast to the conventional notion that all small-caps derive the vast bulk of their revenue from domestic sources, many small-cap companies have a healthy percentage that comes from outside the U.S.
So while the average company in the Russell 2000 derived only 20.3% of its sales from outside the U.S. at the end of September, the percentage of international sales varies widely by sector and industry. In fact, 415 companies in the small-cap index derived a third or more of their revenues from outside the U.S.
In this light, we suspect that even modest global economic expansion can spur solid earnings growth, which should fuel greater relative advances for certain small-cap cyclicals.
To be sure, it remains to be seen if the ‘September Shift’ back to value, cyclicals, and small-cap—accompanied by rising rates—will last or prove to be a short-term phenomenon.
From a market cycle standpoint, we remain convinced that the previous small-cap peak in June 2015 marked a new small-cap cycle. Without trying to pin a specific date as to when a leadership resumption takes a more lasting hold, we believe that this cycle will continue to be led by value (as it was from 6/23/15-9/30/17) and cyclical stocks.
So while we recognize the causes for uncertainty, we also see more than enough reasons to be cheerful about economic prospects—especially on the global level. We believe that solid-to-strong prospects for the global economy combined with relatively more attractive valuations should mean positive outcomes for a certain kind of small-cap company. From our perspective, small-caps in cyclical industries with modest valuations and global exposure look poised to lead —and we are happy to be holding many.
Cyclical and Defensive are defined as follows: Cyclical: Consumer Discretionary, Energy, Financials, Industrials, Information Technology, and Materials; Defensive: Consumer Staples, Health Care, Real Estate, Telecommunication Services, and Utilities. Source: Factset
Enterprise Value (EV) is calculated by adding a company’s market capitalization, long term debt, preferred stock, and minority interest, then subtracting cash. EBIT is earnings before interest and tax. EV/EBIT is a harmonic weighted average.
Article by The Royce Funds