Small caps, after the crisis

No one likes a bear market. But unless we believe the bear is here to stay, there’s probably a clearing at the far side of this volatile period of investing history. As we’ve seen in the past, actions taken during a major market decline can have significant implications for absolute and relative returns moving forward.

If for nothing else, the recent sell-off will be remembered for the speed of its onset and its jaw-dropping depth. From a high on February 20 through March 23—the bottom of the market’s drawdown to date—the Russell 2000 Index fell 41%, and the S&P 500 Index dropped by 34% over the same timeframe.

Looking back over the last 40 years, there’s a short list of periods in which both indexes decreased by 30% or more. What appears to be a relative constant, though, is that small caps tend to fall a bit further than large caps in bear markets, and notably, small caps have also rebounded significantly higher off the bottom.

Investors have repeatedly shown that they prefer small caps when uncertainty recedes and risk appetites return. If we can assume that markets will function at anything approaching normal levels in future quarters, then we believe the time for pursuing high-quality small-cap opportunities is now.

Over the next few months, the outlook for the U.S. economy is not good. As much of the developed world continues on hiatus in response to the spread of COVID-19, we know that top-line revenues for most companies will be extremely weak.

On top of this, corporate debt remains high. According to the U.S. Federal Reserve, there’s US$10.1 trillion of U.S. nonfinancial corporate debt outstanding, which is actually up from US$8.4 trillion three years ago. In this environment, it’s not hard to see the dominoes fall for companies across the capitalization spectrum, but particularly overlevered small caps.

As an investor, it’s impossible to ignore how the volatility has affected most things equally, without regard to fundamentals. During the early weeks of the drawdown, just about everything declined in lockstep because investors who either needed to raise cash or panicked sold what they could.

But this doesn’t mean that the basic building blocks of a normative recovery are gone: Small-cap valuations, for one thing, are extremely attractive. Investors typically require a higher risk premium for small caps. But the FAANG influence, combined with the recent sell-off, has made small caps especially cheap. In fact, the relative relationship is approaching one standard deviation for P/E and is well beyond that level when we consider the ratio of enterprise value to EBITDA for small caps ex-biopharmaceuticals. That’s an extraordinary level of valuation change that’s happened only a handful of times in the last 20 years.

Fundamentals will continue to matter, of course, as will a general ability to adopt a more defensive posture. It’s made sense to us, for example, to reduce exposure to the energy sector, where the price of oil has collapsed; to trim those technology holdings whose supply chains are vulnerable to pervasive trade interruptions; and to limit exposure to those consumer companies whose operations have all but ceased as a result of public lockdowns.

And yet, in a sense, opportunities abound. High-quality, underlevered small caps with ironclad balance sheets continue to operate, including companies in consumer staples, technology, and healthcare. Mobile gaming companies are benefiting from household “nesting,” and there’s no shortage of small tech companies that should benefit from increased levels of working from home. These companies are the technology infrastructure wizards that are enabling widespread and rapid corporate transformation along a brand-new path to digital work, helping businesses solve problems around communication and secure and effective collaboration. In a variety of cases, we see emerging catalysts that could arguably propel strong earnings growth through the other side of today’s crisis.

I’ll close by stating the obvious: No one knows where or when we’ll arrive at the bottom of today’s dislocation, and it would be foolish not to expect more risk-off days ahead. But as active investors, we do see evidence of life among high-quality small caps—names that dominate their niche and have a history of disciplined free cash flow generation with a limited reliance on leverage. We would expect that as investors return to making distinctions among companies, high-quality names with durable long-term demand will rise to the top.