After a long period of underperformance, the last three-plus months have seen an encouraging upward move for micro-caps.
As the year winds toward its close, large-caps continued to hold sizable performance spreads over their small- and micro-cap cap siblings, as measured by the Russell 1000, Russell 2000, and Russell Microcap Indexes. Recent moves, however, suggest that this may be changing.
Source: FactSet, as of 11/30/19. 1Not annualized. R1K = Russell 1000 Index; R2K = Russell 2000 Index; RMICRO = Russell Microcap 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.
What’s of particular interest to us about the latest run of large-cap outperformance is the effect it’s had on valuations. We first looked at the results of this in November, when our research found that small-caps were selling at their biggest discount to large-caps since 2001.
This led us to examine how this performance pattern had affected micro-cap stocks, knowing that their returns have lagged small caps over the last few years. We found at the end of 3Q19 that the 15-month performance spread between mega-caps and micro-caps was nearly a whopping 30%. The Russell Microcap declined 15.6% over this period—the span from 6/30/18-9/30/19—while the Russell 1000 advanced 11.6% and the mega-cap Russell 50 Index did even better, rising 14.2%.
This has created an even more substantial valuation discrepancy between micro-caps and large caps, especially based on our preferred valuation metric, EV/EBIT (enterprise value divided by earnings before interest & taxes). The median EV/EBIT, excluding non-earners, for the Russell Microcap was 17.5x compared to 20.0x for the Russell 1000, both at the end of November. The chart below gives another look—not just how wide this valuation gap has grown but also that micro-caps were trading at their steepest discount to large-caps since 2001.
Russell Microcap vs Russell 1000 Median Relative LTM EV/EBIT Ex. Negative EBIT2 chart
Source: FactSet, as of 11/30/19. 2Last Twelve Months Enterprise Value/Earnings Before Interest and Taxes. 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.
While we think that valuations remain relatively attractive in many corners of the micro-cap world, recent returns show that the performance gap is narrowing, however gradually. A rotation began with the market’s recovery on August 27th following down months in July and August. Since then, the Russell Microcap has beaten the Russell 1000 for three consecutive months—and was ahead in December through the twelfth of that month. (This was one of a group of simultaneous reversals that upended the market leadership patterns that had previously been in place—from 8/27/19-9/30/19 small-caps outpaced large-caps, small-cap value beat small-cap growth, and cyclicals outperformed defensives.)
Of course, our analysts and portfolio managers have noticed that valuations have looked attractive on an absolute basis in many areas of the micro-cap market for much of the last three years. In our deep value, absolute value, and core strategies, they have been very active buyers in the space in areas as diverse as healthcare devices, diagnostics, and testing; paper & packaging; semiconductors and semiconductor capital equipment; chemicals; and consumer finance.
We don’t know if the recent upward move for micro-caps will last or when they will assume market leadership. In our more than four decades of investment experience, however, we have seen similar patterns of long-term underperformance, which often ultimately ended with satisfaction for our contrarian stance.
EV / EBIT equals a company's enterprise value divided by earnings before interest and taxes. It measures the price (in the form of enterprise value) an investor pays for the benefit of the company's cash flow (in the form of EBIT).
Enterprise value (EV) refers to the entire value of a company after taking into account both holders of debt and equity.
The Russell 1000 Index measures the performance of the 1,000 largest companies in the Russell 3000 Index, which represents approximately 92% of the total market capitalization of the Russell 3000 Index.
The Russell 2000 Index is an unmanaged list of common stocks that is frequently used as a general performance measure of U.S. stocks of small and/or midsize companies.
The Russell Microcap Index measures the performance of the microcap segment of the U.S. equity market. Microcap stocks make up less than 3% of the U.S. equity market (by market cap) and consist of the smallest 1,000 securities in the small-cap Russell 2000® Index, plus the next smallest eligible securities by market cap.