Six Things You Need To Know About Small Caps

Six Things You Need To Know About Small Caps

Despite a wild finish, the second quarter was still markedly more bullish and less volatile than the first—and saw a shift in small-cap style leadership that we’ll be watching closely.

Although it finished on a wild and bearish note, the second quarter of 2018 was both markedly more bullish and less volatile than the first. The quarter also saw a late shift in style leadership within small-cap that bears watching.


Source: Bloomberg. Volatility figures based on the CBOE Russell 2000 Volatility Index (RVX) . Return data based on the Russell 2000 Index (R2K). Past performance is no guarantee of future results. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.

Returns for U.S. stocks were solidly positive in spite of several challenging developments, including tariff and trade war talk, a strengthening dollar, market and economic softness in China, slower growth in Europe, and negative news out of Brazil and Argentina.

To varying degrees, all of these developments conspired to make the last weeks of June by far the most volatile of the entire second quarter.

And while results for the major domestic stock indexes were positive in the face of the late downward pressure, most international indexes slipped deeper into correction mode during 2Q18. Indeed, the combination of a modest slowdown in international growth, rising emerging market instability, a stronger dollar, and heightened trade war concerns led investors to prefer all things domestic.

Smaller Was Better

The headlines were arguably more volatile than the markets through most of 2Q18. To be sure, much of the fundamental news was positive. Economic growth in the U.S. continued to accelerate, while most companies continued to post excellent earnings, aided by lower tax rates.


Their greater reliance on U.S. growth left small- and micro-cap stocks much better positioned for superior performance relative to large-caps in the quarter. Another related plus for small-caps was the strengthening dollar, which has often coincided with relatively stronger small-cap results in the past.

All of this made smaller better across the market cap spectrum. Performance was best in 2Q18 for micro-caps, followed by small-, mid-, and large-caps.

As much as domestic economic growth helped to drive results, some of small-cap’s relative advantage can also be attributed to cyclicality and reversion to the mean: both the small cap Russell 2000 and Russell Microcap Indexes underperformed the large cap Russell 1000 Index for calendar 2017 before beginning to move past large-caps earlier in 2018."

Value Makes a Late Move, Tops Growth

Based on a strengthening U.S. economy and related widespread corporate profit growth, it made sense that the Russell 2000 Value Index finished 2Q18 ahead of the Russell 2000 Growth Index.

It was also not surprising that small-cap breadth expanded in the quarter. The equal-weighted Russell 2000 outperformed the capitalization-weighted index, and in doing so reversed another trend from 1Q18.

What was surprising was that more defensive sectors led, rather than those more economically sensitive areas (more on that below).

Whether or not value’s leadership is a more lasting shift, of course, remains to be seen. Having gone through a few favorable moves for value over the last few years that proved short-lived, we are simultaneously wary and optimistic.


Source: Bloomberg. Analysis based on growth and value stocks as identified by Russell in the Russell 2000 Index. Past performance is no guarantee of future results. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.

It seems clear to us that the stage remains set for a longer outperformance phase for small-cap value. The combination of economic growth, rising interest rates, and value’s long-term historical advantage all argue strongly in favor of a more sustained period of leadership.

The conundrum is that these conditions have been present for the last year-and-a-half—a period in which growth has led in five of six quarters.

Energy Hits the Pedal

The top-performing sector in the Russell 2000 was Energy by a significant margin, as the rebound in commodity prices and production made a positive impact on stocks in both the oil, gas & consumable fuels and energy services industries. Defensive sectors Consumer Staples and Real Estate rounded out the top three. These areas were three of the index’s four worst performers in 1Q18, along with Consumer Discretionary, which also came back strong in 2Q18.

It’s also likely that Consumer Staples, Real Estate, and Consumer Discretionary looked particularly attractive to investors anxious about international growth because all three derive a higher-than-average percentage of their revenues from domestic sources.

We suspect that the sector leadership of Consumer Staples and Real Estate will be short lived as each is more interest-rate sensitive and less responsive to a stronger economy, which is precisely the opposite of how we think portfolios should be positioned going forward.

Cyclicals in Neutral

Perhaps the most unexpected result of the quarter was the ongoing lackluster performance for two key cyclical sectors, Industrials and Materials, which sat at the bottom of the small-cap sector performance standings.

Both faced headwinds—dollar strength often leads to weaker commodity prices, which especially hurts Materials, and European growth fell off from its previously fast pace. Moreover, trade war anxiety and a weakening Chinese economy provided additional rationales for investors to be cautious with these stocks—or avoid them completely.

We are on the opposite side of this pessimistic assessment. Our contrarian confidence comes from meetings with company managements who are communicating greater assurance and optimism than we have heard in some time. Their positive expectations are consistent with both PMI (Purchasing Managers’ Index) and ISM (Institute of Supply Management) numbers that continue to show strong manufacturing, production, and order trends here in the U.S.

Thus, we believe that some of the most undervalued opportunities within the asset class can be found in these low-expectation cyclical sectors—many of which boast what we think are excellent earnings and cash flow profiles.

Our Perspective: Lean Cyclical And Stay Active

Particularly in an era of rising interest rates, we are sticking with the view that select small-cap cyclicals with solid balance sheets are best positioned for small-cap leadership.

We see stronger earnings and cash flow prospects in several cyclical industries than we do in growth and/or defensive areas—as well as confident management teams.

We think it’s worth noting that the three changes in the market environment that we expect—lower returns, higher volatility, and value leadership—have all historically been coincident with active management leadership.

The quarter provided some enticing glimmers of further progress on the long road to normalization, most notably via modest increases in bond yields and the reemergence of value’s leadership. We anticipate that other aspects of normalization will emerge as the year goes on.


Note: Investments in small-cap and micro-cap companies involve a higher degree of risk and volatility than investments in larger, more established companies.



IMPORTANT INFORMATION: All investments involve risk, including loss of principal. Past performance is no guarantee of future results. An investor cannot invest directly in an index. Unmanaged index returns do not reflect any fees, expenses or sales charges.

Equity securities are subject to price fluctuation and possible loss of principal. Fixed-income securities involve interest rate, credit, inflation and reinvestment risks; and possible loss of principal. As interest rates rise, the value of fixed income securities falls. International investments are subject to special risks including currency fluctuations, social, economic and political uncertainties, which could increase volatility. These risks are magnified in emerging markets.

The opinions and views expressed herein are not intended to be relied upon as a prediction or forecast of actual future events or performance, guarantee of future results, recommendations or advice.  Statements made in this material are not intended as buy or sell recommendations of any securities. Forward-looking statements are subject to uncertainties that could cause actual developments and results to differ materially from the expectations expressed. This information has been prepared from sources believed reliable but the accuracy and completeness of the information cannot be guaranteed. Information and opinions expressed by either Legg Mason or its affiliates are current as at the date indicated, are subject to change without notice, and do not  take into account the particular investment objectives, financial situation or needs of individual investors.