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Equity Perspectives

Their domestic focus, a strong U.S. dollar, and tax cuts have all combined to give an edge to U.S. small-cap companies.

(Editor’s Note: This is the cover story for the October 2018 issue of Lord Abbett Insights, originally published in September. Although U.S. small-cap stocks have felt the impact of the recent market correction, we believe the underlying fundamentals described in this article still support the asset class going forward.)

For much of 2017, large-cap stocks (as represented by the Russell 1000® Index) outperformed their small-cap peers (as represented by the Russell 2000® Index) with the gap between large- and small-cap stock performance widening to nearly 11% by January 30, 2018. Since February 2018, however, small caps have returned 10.5%, outperforming large caps by more than 6% and narrowing the gap since the start of 2017 to less than 2%. Why has this turnaround occurred?

 

Chart 1. The Gap between Large-Cap and Small-Cap Performance Has Narrowed Since February 2018
Russell 1000 Index and Russell 2000 Index performance, January 1, 2017–August 27, 2018

Source: Morningstar. Large-cap stocks represented by the Russell 1000 Index. Small-cap stocks represented by the Russell 2000 Index. Past performance is not a reliable indicator or a guarantee of future results. For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment.
Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

 

Despite a gap in returns, small-cap fundamentals have remained as strong as, if not stronger than, their large-cap peers. With 97.4% of companies reporting to FactSet as of August 28, 2018, 90% of companies within the Russell 2000 Index had reported second-quarter 2018 earnings and revenue numbers, revealing blended growth rates of 46.13% and 9.69%, respectively. Compare those figures to those of the S&P 500® Index, which reported a blended earnings growth rate of 24.97% and revenue growth of 10.06%.

This fundamental strength, coupled with lagging returns during much of the previous two years, led the small-cap price-to-earnings (P/E) premium [positive earnings per share (EPS) only] to reach its lowest level since 2009 as of August 30, 2018, suggesting that small caps still look very attractive from a relative value perspective.

 

Chart 2. Small-Cap Relative Valuations Are At Their Lowest Level Since 2009
Russell 2000 price-to-earnings (P/E) ratio (positive EPS only) relative to Russell 1000 P/E ratio (positive EPS only), for the period March 9, 2009–August 31, 2018

Source: Bloomberg. Small-cap stocks represented by the Russell 2000 Index. Large-cap stocks represented by the Russell 1000 Index. Past performance is not a reliable indicator or a guarantee of future results. For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment.
Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

 

What might continue to drive this turnaround?

  • For one thing, there is the stronger U.S. dollar. Small caps are more levered to the domestic economy than are larger companies. They also are more likely to sell products domestically, insulating them from the currency translation impact of a stronger U.S. dollar and the resultant loss of competitiveness that their larger peers typically endure when the U.S. economy is strong.
  • In addition, their domestic focus largely insulates them from the trade uncertainties created by a U.S. administration determined to renegotiate global trade agreements—an environment that has added significant volatility to the large-cap market.
  • Small companies also are benefiting, in part, from the December 2017 tax cut, which slashed their average tax rate, from 35% to 21%. This compares with the effective tax rate for large-cap companies, which has fallen, from roughly 27.5% to 22.5%, according to estimates from Credit Suisse.

Conclusion
While there, of course, remain stock-specific opportunities across all market-cap segments, the burgeoning outperformance of small-cap stocks in recent months is in line with the “small-cap” premium that has been observed historically over longer-term periods.

It’s worth mentioning as well that the global economy is beginning to exit the liquidity-driven, quantitative-easing environment of 2009–15 that has been the chief catalyst for large-cap and mega-cap outperformance. In the current market environment, with earnings and revenue growth, rather than liquidity, driving equity returns, investors may be wise to consider small-cap stocks and, perhaps more important, to identify fund managers who have the flexibility to capitalize on opportunities across all market-cap segments, as fundamental strength begins to be recognized across the capitalization spectrum.

 

A Note about Risk: The value of investments in equity securities will fluctuate in response to general economic conditions and to changes in the prospects of particular companies and/or sectors in the economy. Small cap company stocks tend to be more volatile and may be less liquid than large cap company stocks. Small cap companies also may have more limited product lines, markets, or financial resources and typically experience a higher risk of failure than large cap companies. No investing strategy can overcome all market volatility or guarantee future results.

Diversification does not guarantee a profit or protect against loss in declining markets.

This article may contain assumptions that are “forward-looking statements,” which are based on certain assumptions of future events. Actual events are difficult to predict and may differ from those assumed. There can be no assurance that forward-looking statements will materialize or that actual returns or results will not be materially different from those described here.

Statements concerning financial market trends are based on current market conditions, which will fluctuate. There is no guarantee that markets will perform in a similar manner under similar conditions in the future. Past performance is not a guarantee or a reliable indicator of future results.

Glossary of Terms

The price to earnings ratio (P/E ratio) is the ratio for valuing a company that measures the current share price relative to its per-share earnings.

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 measures the performance of the 2,000 smallest companies in the Russell 3000 Index, which represents approximately 10% of the total market capitalization of the Russell 3000 Index.

The S&P 500® Index is widely regarded as the standard for measuring large cap U.S. stock market performance and includes a representative sample of leading companies in leading industries.

Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

The information provided is not directed at any investor or category of investors and is provided solely as general information about Lord Abbett’s products and services and to otherwise provide general investment education. None of the information provided should be regarded as a suggestion to engage in or refrain from any investment-related course of action as neither Lord Abbett nor its affiliates are undertaking to provide impartial investment advice, act as an impartial adviser, or give advice in a fiduciary capacity.

The opinions in the preceding commentary are as of the date of publication and subject to change based on subsequent developments and may not reflect the views of the firm as a whole. This material is not intended to be relied upon as a forecast, or research or investment advice regarding a particular investment or the markets in general, nor is it intended to predict or depict performance of any investment. This material is being provided as general information only and is not intended to be legal or tax advice. Investors should not assume that investments in the securities or sectors described were or will be profitable. This document is prepared based on information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy or completeness of the information. Investors should consult with a financial advisor prior to making an investment decision.

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