Four reasons why U.S. small-cap stocks look attractive despite today’s headwinds

For small caps, it’s been a volatile start to the decade

Small-cap investors have had a rough ride of late, starting with the pandemic-induced sell-off in early 2020. In the subsequent recovery, the Russell 2000 Index, a small-cap benchmark, surged as COVID-19 vaccines were developed and the economy began to slowly normalize. By November 8, 2021, the Russell 2000 climbed to a record high that was 146% above the index’s early pandemic low. However, late 2021 and early 2022 produced several headwinds that hit small caps especially hard: new COVID-19 variants, supply chain disruptions, surging inflation, rising interest rates, and climbing labor and energy costs. Through May 31, the Russell 2000 had fallen more than 23% from its record level.

Amid a tough backdrop, buying opportunities emerge

While veteran small-cap investors may be accustomed to such volatility, it’s also important to be aware of the potential for long-term investment opportunities that can emerge when negative catalysts appear to outnumber the positives. While we view today’s market as having an abundance of both, we believe today’s tailwinds are collectively stronger than the headwinds. In our view, it’s a uniquely opportune time to be an active small-cap investor, although we do expect rough patches in the near term as the economy is buffeted by recessionary risks such as rising rates and persistently high inflation.

Here are four tailwinds that we’re seeing as we pursue opportunities at the individual security level across small caps:

1)      Low valuation—Recent earnings results and small caps’ decline from their historic market peak in November 2021 have left the Russell 2000 at its most inexpensive level relative to large caps in more than two decades, dating to the period when the technology stock bubble burst in 2000. As of May 31, 2022, the index’s relative price-to-earnings ratio based on the past 12 months of earnings was 0.63 as measured against the S&P 500 Index, a large-cap index. That relative valuation difference made small caps far less expensive than their long-term average of 0.95 dating to January 31, 1998.

2)      Brighter earnings and revenue outlooks—Although comparisons with the recovery year of 2021 have been tough, small-cap earnings have still been growing at a healthy clip. For 2022 and 2023, Wall Street analysts’ forecasts for full-year earnings growth were higher for Russell 2000 companies than for S&P 500 companies as of May 24.

3)      Inflation may be easing—While rising U.S. inflation has persisted longer than the U.S. Federal Reserve (Fed) had expected, we believe that we’ve transitioned out of a period of pandemic-related inflationary pressures. While the Russia-Ukraine war and continuing supply chain disruptions have prolonged elevated inflation, we expect inflationary pressures to eventually moderate, leading to a mostly positive environment for equities—particularly for small caps.

4)      Economic recovery could provide a catalyst—Even if we do see a recession in the near term, we expect that the downturn would be relatively brief compared with past recessions. Furthermore, while large caps have historically tended to outperform small caps during recessions—that is, by declining to a lesser degree—the performance edge has often flipped in the postrecession recoveries that followed. In fact, small caps have outperformed large caps in each of the 12-month periods that followed the past six U.S. recessions declared by the National Bureau of Economic Research, according to performance figures from investment data provider eVestment. The margins for small caps have been big, with an average 28.4% return for the Russell 2000 Index during those periods versus 15.6% for the S&P 500 Index. 

Risks to small-cap outperformance potential

While we maintain a positive long-term outlook for small caps, several near-term headwinds pose risks that complicate the outlook through the rest of this year and perhaps beyond. The pace of interest-rate increases that the Fed ultimately approves this year will be important to watch. Furthermore, the persistence of inflation and supply chain bottlenecks, as well as the increasingly protracted nature of the Russia-Ukraine war, continue to complicate the economic growth outlook, strengthening the role that macroeconomic forces play in driving equity markets and often overwhelming company-specific fundamentals. 

Small caps for the long term

Despite these current risks, we believe that the unusually high influence that macroeconomic forces have recently exerted on equity markets is likely to ease, as is the disconnect that these forces have created with the strong fundamentals at many small-cap companies today. We continue to see abundant opportunities in select, high-quality companies—especially those with strong balance sheets to help navigate an environment in which credit becomes more expensive and less readily available amid rising rates. Given these bottom-up opportunities and the historically low valuations across small caps broadly, we see a fertile current environment for active fundamental investing emphasizing a core small-cap approach, with blended exposure across the growth and value equity style spectrum.