Summary: U.S. small cap stocks have been doing really well lately. What’s more, small cap VALUE stocks are outperforming their GROWTH counterparts, a trend that MRP expects to eventually extend to the large cap value segment of the market as well. That’s because the current economic landscape is more favorable for value than growth stocks.
The long-awaited rotation from growth stocks into value appears to be finally happening, and it’s starting in the small cap space.
During the current U.S. equity bull market, growth stocks have trounced their value counterparts. Between the March 9, 2009 stock market bottom and the end of 2017, the large cap growth ETF (IWF) and the large cap value ETF (IWO) delivered respective gains of 248% and 267%. In contrast, the large cap value ETF (IWD) and the small cap value ETF (IWN) rose 186% and 180%, respectively. As evident from these numbers, investor preference for growth over value manifested itself across all market capitalizations during that time.
This year, however, market cap is playing a bigger role in the investment allocation process as evidenced by the fact that the Russell 2000 index of small caps hit a fresh record high on Monday. It’s now up nearly 8% this year (see IWM ETF) while the Russell 1000 index of large caps (see IWB ETF) has risen about 2.5%, the S&P 500 is up 2%, and the Dow, which got hit with two corrections this year, is virtually flat. Even more interesting, small cap values stocks have been leading for the past three months.
Several factors are driving the shift into U.S. small caps in general and small cap value stocks more specifically, including changes to US fiscal policy, deregulation, and faster US GDP growth, and valuations among other things.
TAX CUTS: The small-cap comeback is partially driven by the Trump administration’s corporate tax cuts which took effect this year, and stand to benefit smaller companies more than large ones. While larger firms have big teams constantly working to reduce their tax bill, small businesses typically pay their full tax bill with designated rates. The tax cut, therefore, would have a much larger real benefit on these smaller companies.
IMPROVING ECONOMIC CONDITIONS: Small-cap companies tend to be more domestic-focused in terms of where they derive their revenues. As such, they are now benefitting from strong U.S. economic growth, rising asset prices, and a robust labor market which are making Americans feel wealthier, and in turn encouraging consumer spending. This trend should continue, given that the Atlanta Fed’s GDPNow model is projecting real GDP growth of 4.8% for Q2 2018; Small Business Optimism Index is near record highs in the Survey’s 45-year history; and a capex boom is underway thanks to a new expense provision in the Trump tax bill that allows companies to take a 100% deduction on certain capital investments, thereby greatly reducing after-tax cost.
The domestic focus of small cap companies generally insulates them from the trade war concerns and geopolitical tensions hanging over multinational American companies these days. The also tend to be less affected by headwinds from a stronger dollar that would impact firms with international revenues.
DEREGULATION: The administration’s recent efforts to loosen regulation are also proving to be a boon, particularly for regional banks which fall in the small cap and value group of stocks.
VALUATION: Growth stocks, led by the FANG, have dominated for so long that they’ve become expensive relative to value stocks. Lower valuations are another major reason small cap value stocks have become more attractive. Large-cap stocks, for example the Schwab US Large-Cap ETF (SCHX), were trading at 21 times one-year-forward earnings as of January, while small-cap value stocks such as the VBR, historically around the same level, were trading at only 14 times, making them a bargain buy.
The transition in leadership to small cap value stocks could bode well for the broad thematic rotation from growth into value stocks that MRP has been anticipating. That’s because we are now in an era of tightening U.S. monetary policy. So, as interest rates rise, the discount rate in the present value equation should rise accordingly. As such, companies’ discounted future earnings will be revalued downward – an effect that negatively impacts growth stocks more than value. So, while rotating out of growth stocks and into value is considered a contrarian play for now, that may not be the case for very long.
Some MRP themes already fall into this value bucket, including Long Regional Banks (KRE), Long Energy (XLE), and Long Industrials (XLI). Paradoxically, the cheapest sectors in the market – the ones investors have ignored in favor of FANG and other growth stocks – are the ones that are most positively exposed to yields going up, including banks and the energy sector.
We’ve also summarized the following articles related to this topic…
Stocks: Small-Cap Stock Boom Spurs Most Inflows Since Trump Victory
ETF investors haven’t been this “America first” since Donald Trump won the presidential election — at least if flows to small-cap companies are any guide. Last month, roughly $7.5 billion poured ETFs focused on small-cap stocks, the most since November 2016. The flows are following strong performances by small-cap stocks. The Russell 2000 index gained 6% in May, the best month for the gauge since September.
What’s driving the activity? A confluence of goodies for domestically oriented companies, as tax overhaul benefits kick in amid trade tiffs and a stronger U.S. dollar, all of which makes them more attractive than big international companies.
By one measure, small caps are outpacing their larger brethren by the most in 16 years. The three-month premium on the S&P Small Cap 600 index over the S&P 500 index is at a level not seen since May 2002.
Some investors are concerned that the strong performance won’t continue. Matt Maley, an equity strategist at Miller Tabak, added that small-cap stocks could run out of steam when the rising dollar starts to slow down. IBD
Stocks: Small-Cap Stocks Are on Their Hottest Run Since 2002
Small-cap stocks as tracked on the S&P Small Cap 600 outpaced the larger S&P 500 by 9.5% from February through May. Following that hot streak, the small-cap index now outperforms large caps at a three-month premium level not seen since May 2002.
Outperformance this big has only happened in a three-month period 12 times since September 1989. And, for the first time since December 2016, all 11 small-cap sectors posted gains last month. It’s a quick turnaround from February, during which all 11 sectors were negative for the month.
Healthcare measured outperformance of small caps over large caps of about 9%, analysts found. Consumer staples had almost as much of a small-cap premium as healthcare in May, up about 8.8% compared to larger firms.
“Smaller consumer staples companies historically do better from GDP growth, gaining on average 5.9% per 1% of growth, as compared to the large caps that rise just 4%,” according to S&P’s Head of U.S. Equities Jodie Gunzberg. Additionally, rising rates are more of a boon to small-cap consumer staples than large cap. “For every 100 basis point increase, small-cap consumer staples rose 7.2% on average historically, whereas the same rate hike has only pushed large-cap consumer staples companies up 4% on average,” S&P said. TheStreet
Stocks: Value Investors Face Existential Crisis After Long Market Rally
Hunting for cheap stocks has been out of favor for so long that some self-proclaimed “value” investors are embracing a broader mandate, a potentially costly move in the later stages of an economic cycle.
Value stocks have been stuck in a rut for most of the nine-year rally in U.S. stocks. The Russell index of 1,000 of the biggest value stocks in the market has fallen 2.1% in 2018, the fifth straight year—and the 10th of the past 11 years—that the index has lagged behind its growth counterpart, which is up 6.9%.
Some critics say the measures used to identify value have aged poorly in a market dominated by passive investing strategies and asset-light technology companies. Those trends have pushed more investors into the shares of fast-growing companies such as Apple Inc. and Netflix Inc. that have powered the market higher in recent years. Other investors have turned to studying momentum trading, crowded positions, fund flows and event-driven trading, strategies not typically associated with value investing.
Many investors say they aren’t looking back, even as most analysts generally agree the U.S. is in the later stages of an economic cycle. That would suggest stocks are due for a pullback, putting investors who have altered their strategies at risk of missing out if the pendulum swings back in favor of traditional value stocks. WSJ
Stocks: Twitter was just added to the S&P 500 — here’s what that means for its stock
It was announced on Monday evening that Twitter would replace Monsanto in the S&P 500, starting June 7. It marks the culmination of a rocky ride for Twitter, whose stock price nearly tripled in mere weeks following its initial public offering in November 2013, only to drop 80% over the following 2 1/2 years. That took the stock 46% below its IPO price of $26 at one point.
Shares have skyrocketed 170% since then, and now sit at $37.88, having spiked 58% in 2018 alone. That includes a 5% gain on Tuesday as the news of Twitter’s index addition was priced into the company’s stock.
So what does this momentous occasion truly mean for the future of Twitter’s stock?
- An immediate stock boost: Companies normally spike upon being added to major indexes, and Twitter is proving to be no different.
- A broader and more diverse group of shareholders: One major aspect of being included the S&P 500 is that a company becomes a small cog in a massive universe of index funds that track the benchmark.
- More liquidity, and more volatility: Any trade you make on the benchmark will involve the transaction of that Twitter portion as well, however minuscule. BI