Behavior and Fundamentals Favor Small Cap Value

Friday, March 18th, 2016
Written by Manifold Fund Advisors

With the U.S. insulated from global slowdown despite accompanying investor fears, more small cap stocks are available at bargain prices, particularly compared to their large cap cousins. Additionally, increased merger and acquisition activity of smaller companies is encouraging the trend to return to historic outperformance. Together, these signals are increasing favor for small cap value stocks in 2016.

Signal #1: Domestic markets show some signs of growth against a global backdrop.

Last year’s rate hike by the Federal Reserve is considered a sign of strengthening U.S. economic growth. Coupled with an increase in the Consumer Price Index (CPI) (graph 1), lower unemployment rate, and a strengthening U.S. dollar, the move has helped create an attractive domestic market for foreign investors. In contrast, the Bank of Japan and European Central Bank recently pushed interest rates below negative, and there is a United Kingdom referendum due later this year on whether to remain in or leave the Eurozone.

Graph 1: CPI growth from January 2013 to February 2016

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Source: Federal Reserve Bank of St. Louis FRED database1

Opportunity: Small caps are concentrated domestically, providing a “pure play” in U.S. economic growth.

Since most small companies tend to do business in the U.S., small cap stocks are not exposed to the same amount of global sensitivity as large caps. Some observers argue that small caps should be more insulated from macroeconomic forces than their large cap peers,2 with small caps generating only 19% of revenue internationally, compared to large cap stocks which generate 28% of sales from outside the country.3 Analysts anticipate Russell 2000 company earnings to grow 9.8% in 2016 (small cap), whereas S&P 500 companies are expected to see growth of 7.6% (large cap).4 This domestic environment creates an opportunity for small cap investments to benefit.

Signal #2: Fear-driven selling had investors leaving small caps faster than large cap stocks.

Small cap stock indexes were not the only major indexes hit hard in early 2016, but small caps have been hit almost twice as hard, losing about 20% in the past few months, with some stocks seeing undeserved declines of 30% to 50%.5 This drop is driven in part by fear from major market corrections and the lower liquidity of small company stocks, exposing these securities to the possibility of short trading which can further diminish the price. Some of this selling is thought to be correlated to tax-loss selling at the end of 2015.6

Opportunity: Low prices create bargains in small cap value, especially when driven by behavior.

Value stock investing is principally based on the idea of picking stocks that are undervalued. When a major movement, as with the move from small caps, is influenced by emotional behavior, the effects can be greater than economic data alone would suggest. With large caps not far behind small caps (the S&P 500 Index has slumped 7.5% this year with some large cap stocks down at least 20%7), there is opportunity to find bargains through buying small cap and small cap value stocks now.

Signal #3: A heightened trend in merger and acquisition activity.

Merger and acquisition (M&A) activity tends to be positively correlated to U.S. Gross Domestic Product (GDP) growth and market returns, and when combined with low interest rates and healthy corporate balance sheets can make for an accommodative environment.8 The last two years have seen substantial jumps in the volume of announced deals (graph 2), and corporate balance sheets still hold lots of cash.

Graph 2: U.S. merger volume by year, 2009-2015

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Source: Bloomberg L.P.

Opportunity: Smaller companies can boost profitability and returns through merging or being acquired.

Continued acceleration of M&A activity may provide an attractive environment for small cap sectors, allowing faster growth for small companies than can be achieved organically. The generally accompanying greater deal volume can benefit smaller companies through higher equity multiples or increased premiums for shareholders. It is an indicator of business health and provides the opportunity to increase production, reduce costs and put cash to work for a higher return—all of which can increase the stock price for the company.

Signal #4: Small cap value stocks have been below their historical performance.

In the long-term, small cap stocks outperform large cap, and value tends to outperform growth (known as the “value premium”9). From 1980 to 2010, small cap value stocks averaged greater performance than all other equity categories, there’s a 2011 study from Fidelity on this, “Comparing the results of value and growth stock market indexes.” From January 1979 to December 2014, small cap value stocks outperformed small cap growth, returning 13.0% compared to 9.7% a year (according to the Russell 2000® Value and Growth indices).10 In the past two years, small cap has underperformed large cap,11 and small cap value has underperformed small cap growth.12

Opportunity: Small cap and small cap value stocks may be poised to return to historic outperformance.

Part of the phenomenon known as the “value premium” is a return to value stocks after a major market correction following a period focused on performance (as in a bull market), which hasn’t also been focused on risk-adjusted returns. For instance, from 2000 to 2008 value did better than growth, as measured by the Russell 2000® Value and Growth Indexes (chart 1). Since then, growth has done better.

Chart 1: Annual returns of the Russell 2000® Value and Growth Indexes from 2000-2008

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Source: Bloomberg L.P.
The indexes do not incur fees and expenses and are not available for purchase.

If history is any guide, there is the prospect of small caps returning to outperformance over large caps, and of value stocks outperforming growth—two instances that create an investing opportunity for small cap values stocks.

What this means for investing in small cap value.

With the insulation from global slowdown, lower prices, merger and acquisition activity, and the effects of value premium, in our opinion, small cap value stocks are more attractive than they have been since 2011.

1 US. Bureau of Labor Statistics, Consumer Price Index for All Urban Consumers: All Items [CPIAUCSL], All Items Less Food and Energy [CPILFENS], retrieved from FRED, Federal Reserve Bank of St. Louis. https://research.stlouisfed.org/fred2/series/CPIAUCSL, March 17, 2016.

2 Dan Strumpf, “Morning MoneyBeat: Small Caps May Be Ready to Shine (For Real, This Time).” Wall Street Journal. Dec 30, 2015. http://blogs.wsj.com/moneybeat/2015/12/30/morning-moneybeat-small-caps-may-be-ready-to-shine-for-real-this-time/. Accessed March 11, 2016.

3 “The Case for Active U.S. Small-Cap Value.” Investment Voices, Brown Advisory. February 2015. http://www.brownadvisoryfunds.com/media/pdfs/Case_For_Active_US_Small_Cap_Value.pdf. Accessed March 15, 2016.

4 Tom Lydon, “Small-Cap Value ETFs Pick up Steam.” ETF Trends. December 30, 2015. http://www.etftrends.com/2015/12/small-cap-value-etfs-pick-up-steam/. Accessed March 11, 2016.

5 “Ridiculous Drop In Small-Cap Stocks Creates Bargain Opportunities.” Seeking Alpha. Feb 15, 2016. http://seekingalpha.com/article/3896636-ridiculous-drop-small-cap-stocks-creates-bargain-opportunities. Accessed March 15, 2016.

6 Ibid.

7 Philip Van Doorn. “21 large-cap stocks that are down at least 20% in 2016.” MarketWatch. Jan 14, 2016. http://www.marketwatch.com/story/21-large-cap-stocks-that-are-down-at-least-20-in-2016-2016-01-14. Accessed March 16, 2016.

8 “The Case for Active U.S. Small-Cap Value.” Investment Voices, Brown Advisory. February 2015. http://www.brownadvisoryfunds.com/media/pdfs/Case_For_Active_US_Small_Cap_Value.pdf. Accessed March 15, 2016.

9 Fama and French, “The Value Premium and the CAPM.” Journal of Finance, 2006.

10 “The Case for Active U.S. Small-Cap Value.” Investment Voices, Brown Advisory. February 2015. http://www.brownadvisoryfunds.com/media/pdfs/Case_For_Active_US_Small_Cap_Value.pdf. Accessed March 15, 2016.

11 “Ridiculous Drop In Small-Cap Stocks Creates Bargain Opportunities.” Seeking Alpha. Feb 15, 2016. http://seekingalpha.com/article/3896636-ridiculous-drop-small-cap-stocks-creates-bargain-opportunities. Accessed March 15, 2016.

12 David Sims. “Small Cap Value Should Outperform In 2016.” Seeking Alpha. Feb 3, 2016. http://seekingalpha.com/article/3860746-small-cap-value-outperform-2016. Accessed March 15, 2016.

Important Disclosures

The views and opinions expressed in this article are for informational purposes only and not for the purpose of providing investment advice, are those as of the date of the article and are subject to change over time or at any time, and may differ from the firm as a whole. Strategies discussed in this article do not ensure a profit and cannot protect against losses in a declining market. The investment strategies discussed are not appropriate for every investor and investors should review with their advisors the appropriateness of any investment strategy. Manifold Fund Advisors, LLC makes no guarantees on the completeness or accuracy of information provided herein.

CPI – Consumer Price Index (CPI) is a measure used to assess price changes associated with the cost of living.

GDP – Gross Domestic Product (GDP) is the market value of all officially recognized final goods and services produced within a country in a given period of time.

The Russell 2000® Value Index measures the performance of those Russell 2000® companies with lower price-to-book ratios and lower forecasted growth values. The index does not incur fees or expenses and is not available for purchase.

The Russell 2000® Growth Index measures the performance of those Russell 2000® companies with higher price-to-book ratios and higher predicted and historical growth rates. The index does not incur fees or expenses and is not available for purchase.

The S&P 500 Index has been widely regarded as the best single gauge of the large cap U.S. equities market since the index was first published in 1957. The index does not incur fees and expenses and is not available for purchase.

No part of this material may be (i) copied, photocopied or duplicated in any form by any means, or (ii) redistributed without the prior written consent of Manifold Fund Advisors, LLC.

Investing involves risk. Equity securities are more volatile and carry more risk than other forms of investments.

Equity Securities Risk. In general, prices of equity securities are more volatile than those of fixed income securities. The prices of equity securities fluctuate, and sometimes widely fluctuate, in response to activities specific to the issuer of the security as well as factors unrelated to the fundamental condition of the issuer, including general market, economic and political conditions.

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Small-Cap Securities Risk. Investments in small cap companies may be riskier than investments in larger, more established companies. The securities of smaller companies may trade less frequently and in smaller volumes than securities of larger companies. In addition, small-cap securities can be subject to more abrupt or erratic share price changes than larger, more established companies. Securities of these types of companies have limited market liquidity, and their prices may be more volatile.

Value Stock Risk. “Value” stocks can perform differently from the market as a whole and from other types of stocks. Value stocks may decline in value or never reach the value the Sub-Adviser believes is its full market value, either because the market fails to recognize what the Sub-Adviser considers to be the company’s true business value or because the Sub-Adviser’s assessment of the company’s prospects was not correct.

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