Last week, we covered the age old question of “Domestic vs. International”. Let’s make this a bit more intimate with a more recently debated topic, given the rally in cyclicals –Small v. Large. Many of y’all have heard my spiel on this numerous times –get ready for it again.
Over the next few weeks, I’m going to put out a series of analysis on 2021, hitting some of the bigger relative opportunity sets within the equity market:
1. Week 1: Domestic v. International
2. Week 2: Small v. Large
3. Week 3: Value v. Growth
2021 Performance Recap
Both active and passive U.S. Small Cap funds may need to send their clients bumper stickers that say, “Have you Hugged your Small Cap Manager Today?” – U.S. Small Caps have underperformed U.S. Large Caps for five straight years. Even worse, this past year, 2021, U.S. Small Caps underperformed U.S. Large Caps by the largest spread since 1998 – ~14%. But, on the bright side, in years when GDP and inflation are above average (which is expected in 2022), even while the Fed is hiking, small tends to beat large by nearly 400bps. For the first time since ’95 to ’97, U.S. Small Caps delivered three consecutive years of double-digit gains. However, the performance was front-end loaded, as U.S. Small Caps were unable to break out of its 9-month range and only briefly surpassed its 3/15/21 high.
The big thing that stands out to us, from a performance standpoint, is that within U.S. Large, Growth outperformed Value – led by the larger tech names, i.e., NVDA, etc. But that was not the case if you went lower in the market cap spectrum. The Russell 2000 Value (“R2KV”) had quite the comeback vs. the Russell 2000 Growth (“R2KG”) with the difference of 25.5% for the year – being the second-widest in history with only ’00 being bigger. Jefferies went back and looked at periods when U.S. Small Value beat Growth by more than 10%, looking for the next year’s return and we found it still looks good. The R2KV beats the R2KG by an average of 4.7% and did so 9 of 12 periods.
The reason for the underperformance was the fact that the R2KG is littered with non-earners and biotech stocks, which underperformed last year, while the R2KV is heavily weighted in banks, which outperformed. It truly shows that one needs to understand the underlying composition of an index before investing.
h/t Jefferies for a lot of this historical data.
Framing the small-cap landscape:
- The Top 5 names in the S&P 500 have a total market cap of $9.5T, over 3x larger than small caps, these stocks trade at 8.7x price-to-sales vs. <3x for the Russell 2000.
- With record IPO activity, the number of publicly traded stocks rose to 3,384 names, and we will see this number head much higher. Increased IPO action tends to bode well for small cap performance.
- The performance by the R1G was again very concentrated with the Top 10 contributors accounting for 61% of the index’s return. This is two years in a row in which this index was driven by the Top 10.
More importantly, when comparing performance, valuation metrics, and growth compositions for both U.S. Large and U.S. Small, it’s imperative to understand the sectors exposures underneath the hood of each asset class.
Know the Small Cap v. Large Cap Composition:
- Simply put, depending on where you allocation, you have some substantial bets:
- U.S. Large: Investors are betting on Technology, specifically the mega-caps.
- U.S. Small Value: Investors are betting on cyclicals and Financials, i.e., banks and Energy.
- U.S. Small Growth: Betting on non-earners (close to 50% of the index) and biotech /pharmaceuticals.
Source: Bloomberg as of 1/17/2022
Yield + Growth Framework:
The Known: Yield
Indicated Yield:
-U.S. Large:1.27%
-U.S. Small: 0.98%
The Unknown: Growth
Next 12 Months Growth:
-U.S.Large:9.0%
-U.S. Small: 15.9%
Even though both the earnings and sales revision ratios fell, Q4 and ’22’s earnings growth has held up, at least for now. We see that Q4 numbers have been nudged upward from original estimates in September, with both size segments expected to see growth of 22% during Q4. As for ’22, we did see Small edge lower to 15.9% when it stood at 17.7% as of September 30, while large stayed static at 9.0% for Large.
Market Sentiment: Valuation
Next 12 Months P/E:
-U.S. Large: 21.54x
-U.S. Small: 15.31x
Given the substantial underperformance by small caps, we have seen our relative valuation model continue to fall back to ’20 levels. Historically, U.S. Small Caps have traded, on average, at a 4% premium to U.S. Large Caps. As of January 13, U.S. Small Caps trade at a 29% discount.
Fed tightening cycles have historically been accompanied by positive returns for both small and large caps, but multiple contraction in both size segments. Large cap multiples have typically contracted more: during both the first six months and first 12 months of the tightening cycle (where cycles have lasted 1.5 years on average).
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