Over the last decade, two major trends—low interest rates and the growth of index funds—have had a profound influence on small-cap stocks, in our view distorting the market and subjecting passive index investors to new risks. That said, we believe the small-cap segment continues to hold significant opportunities—not in indices, or strategies that closely adhere to index-like holdings, but with a focus on fundamentals that can help mitigate common risks and capitalize on the segment’s appealing growth characteristics. Given the unusual nature of dynamics since the 2008 financial crisis—including uninterrupted, monetary policy-driven expansion—we believe it’s especially important to take a long-term perspective regarding past results and what to anticipate going forward.
Rates and Indices
The story of post-crisis monetary policy has been well-chronicled. Facing the implosion of the global financial system, central banks instituted extraordinary monetary accommodation, including zero (and sub-zero) interest rates and quantitative easing. Even with the Federal Reserve’s post-2015 rate increases (and recent course correction), interest rates have never remained so low for so long.
Contrasting Rate Regimes
Source: Jefferies, Federal Reserve System. Data through September 30, 2019.
The impacts have been far-reaching. Low rates helped drive a record-long U.S. economic expansion, and contributed to an exceptional bull market in equities: From the market bottom of March 9, 2009 until September 30, 2019, the S&P 500 and Russell 2000 returned an annualized 17.4% and 16.5%, respectively, compared to -4.8% and -0.8% in the previous, very choppy, decade.1 Over the roughly 20-year period, the two indices returned 6.3% and 8.0%, which is close to the 6% to 8% long-term return assumptions used today by many institutions. We think 20 years arguably serves as an appropriate time period over which to measure a full market/economic cycle.
Loose central bank policy had other key impacts, including rapid growth in corporate borrowing and an extremely forgiving environment for many lower-quality companies. The effect has been particularly notable in the small-cap universe, where debt is at record levels, and the percentage of loss-making companies relative to large caps is at a historical peak.
Bring on the Debt
Relative Net Debt / EBITDA (ex. Financials) Russell 2000 Index vs. S&P 500 Index
Source: BofA Merrill Lynch. Data through September 30, 2019.
Hold the Earnings
Source: Furey Research Partners and FactSet. Data through June 30, 2019. The percentage of loss-making companies based on number of names was calculated by determining the number of benchmark holdings that have negative trailing GAAP earnings and dividing that total by the total number of names in the overall benchmark. The percentage of loss-making companies based on percentage weight was calculated by determining the number of benchmark holdings that have negative trailing GAAP earnings and adding up the total weight in the index. This information was calculated for both the Russell 2000 and the S&P 500 on a quarterly basis over time. The line above was calculated by taking the difference in the percentage of loss-making companies in the Russell 2000 minus those of the S&P 500.
Not only has generous monetary policy contributed to a deterioration of quality in the small-cap space, but it has also distorted the impact of fundamentals on stock performance. In the years leading up to the financial crisis, perhaps not surprisingly, money-making companies within the index significantly outperformed money-losing companies; but since the market trough in early 2009, there has been little differentiation between the two groups. And why would there be? For most of this recent period, central banks were providing near-zero-cost financing to companies, many of which held only a vague promise of earnings far in the future.
When Quality Doesn’t Count
Relative Performance of Russell 2000 Earners vs. Non-Earners (Based on Forward 1-Year Earnings Estimates)
Source: BofA Research, Russell Investment Group. Data through September 30, 2019.
With performance skewing away from fundamentals, many active managers found it difficult to match, let alone outperform, their benchmarks. In the 10 years through March 2009, roughly 82% of active small-cap blend mutual funds outperformed the Russell 2000 Index, but from April 2009 to September 2019, just 38% outperformed.2 This weakness likely helped move investors toward passive vehicles such as index funds, whose growth has accelerated markedly in the last decade.
A Surge in Passive
Source: Furey Partners. Based on active managers currently in Morningstar’s Small Blend Category. Data as of December 2018.
Interestingly, this drift into passive investing has reinforced the tendency of markets to gloss over differences among companies. By definition, an index will buy (or sell) all of its constituents regardless of their fundamentals. So, as the size and influence of indexes have grown, active investors have seen their role weaken as an arbiter of price. This has contributed to higher correlations among stocks, which in turn has favored index performance, and so on.
Present Concerns and a Long-Term Lens
After looking back at an extraordinary decade, investors may wonder what’s in store moving forward for small-cap stocks. One reality is that, writ large, small-cap indices now carry exceptional risk. Volatility has always been a fact of life in the small-cap universe, which is generally made up of less-established companies of varying quality. Faulty business models, aggressive accounting practices and questionable governance are all meaningful issues. (Although not involving a public company, problems at WeWork highlighted some of the dangers associated with emerging, untested businesses. See article.) But without share prices actually reflecting those differences, the Russell 2000’s current cyclically high exposure to high-leverage, non-earning companies makes it more vulnerable to economic or policy shocks—whether due to potential recession or a return to Fed rate-tightening.
In general, small-cap companies have a higher cost of capital than larger-cap companies. And many have credit ratings that are below investment grade, which means that they can face obstacles to issuing longer-term debt. Today, the average maturity of small-cap-issued debt is just five years, compared to nine years for large caps,3 meaning that many smaller companies are facing refinancing sooner rather than later. For some, an economic downturn could make obtaining new loans a major challenge. Another worry is that many rely on floating-rate debt for funding; should interest rates rise, some companies may find that their cost of capital becomes prohibitive.
Capitalizing on Inefficiency
The good news is that investing in small caps doesn’t necessarily mean investing in indexes. So, the variation in quality that may be a detriment in the passive context could be a real advantage where well-positioned active managers are concerned.
The small-cap universe has always been inefficient, but recently has become more so. Research reports from investment banks and brokerage firms do not cover all companies, and tend to favor underwriting clients. Industry changes have undermined independent research firms, which were often the source of more reliable insights. The net outcome is reduced, lower-quality information in a space where it is particularly valuable.
Sparse, Uneven Research Coverage of Small Caps
Source: Thomson/IBES, FactSet. Data as of June 30, 2019.
As a result, it has become harder to gather the data needed to assess company fundamentals and make decisions to commit capital. Unfortunately, portfolio managers often don’t have the scale to apply the resources they need, or experience across a full market cycle. Of the 552 active small-cap funds tracked by Morningstar, the median fund has only $217 million in assets; and only 40% of funds have been in business for a full two decades—arguably the full length of the current economic cycle.4 In contrast, those with the personnel, insight and technical capability may have a decided advantage as they navigate the small-cap universe. As such, they may be able to access companies that look decidedly different from the index, whether that means steady business models, strong balance sheets, healthy cash flows or dividend growth, among other attractive characteristics.
For some time, difference from the index often wasn’t an advantage within small caps. However, the great downward move in interest rates may be near its conclusion, economies remain on uncertain ground on a global basis, and company fundamentals may resurface as a potential driver of individual stock results. To us, reliance on the non-judgment of passive vehicles just doesn’t seem logical.
Regardless of one’s views on indices, however, we think it is now particularly important to take a long-term perspective in considering the small-cap universe. The past decade has been free of economic downturns and the associated major market drawdowns, and has been quite different from the years that came before. Assessing performance over a full market cycle (15 or even 20 years in this case) can provide a deeper, perhaps more representative, understanding of risk and reward. If you were buying a business, you wouldn’t just look at its results in good times, you would look at them in bad times as well. Portfolios deserve the same level of care.