Although small-cap stocks have performed well over the past decade, they have tended to underperform the large-cap stocks that have propelled the US equity bull market to record highs. In 2019, for example, many investors seemed to be concerned about how smaller companies would fare in a potential US economic slowdown, and they instead leaned toward larger, more well-known names.
As we move deeper into 2020, we see five reasons why investors might want to reconsider small-cap stocks. As value investors, we see stocks in this part of the market that fit our investment philosophy and which we think offer good potential.1
Reason #1: Excessive Pessimism
As the chart below shows, at the end of 2019, small-cap value stocks in the Russell 2000 Value Index were trading near the lowest levels in 10 years, compared to the large-cap value stocks in the Russell 1000 Value Index, as measured by price-to-earnings (P/E) ratios.2
We see a few reasons for this investor pessimism, including a belief that all small-cap stocks are more susceptible to a downturn in the US economy. Although that’s true for many stocks in the Russell 2000 Value Index, it’s not true for all of them, particularly select small-cap value stocks that have higher margins, lower leverage and decent earnings growth.3
As value investors, we believe these characteristics can lead to favorable long-term performance. Although investors have favored large-cap stocks over the past decade, small-cap value stocks have outperformed large-cap stocks over the 20 years ended December 31, 2019, as the chart below shows.4
Reason #2: Small-cap Stocks Are Not Pricing in a Rebound
Since many investors perceive smaller companies to be more sensitive to the economic cycle than larger companies, there is a belief that economic growth needs to improve for small-cap stocks to be successful. We have seen evidence that the US economy is doing well, and certain areas—particularly manufacturing—may be poised to improve.
In January, the US Manufacturing Purchasing Managers’ Index (PMI) rose above 50 for the first time since July 2019.5 Although this number is nowhere near full expansion territory, it does indicate to us that the manufacturing economy may be in the early stages of bottoming. As the chart below shows, small-cap value stocks have tended to perform well for the 12-month periods following a rebound in PMI.6
Our positive view is supported by the recent “phase-one” trade deal between China and the United States, as well as the expected enactment of the United States-Mexico-Canada Agreement (USMCA)7, which should provide relief to the US manufacturing sector.
In addition, the US Federal Reserve has shifted away from the interest-rate tightening we saw back toward the end of 2018, which triggered some small-cap weakness. Many global central banks are also injecting stimulus into their economies to boost growth.
At the same time, US housing data have been improving over the last 12 months and US consumer spending remains healthy.
Reason #3: The “Value Stock” Label Doesn’t Mean Earnings Can’t Grow
As value investors, we seek to avoid unprofitable companies, particularly those that are structurally challenged, and find those that have positive earnings growth potential. Despite the common perception among many investors that small-cap stocks are unprofitable, our research shows that about 70% of small-cap stocks do make money.8 If you exclude negative-earning companies, earnings per share for companies in the Russell 2000 Value Index grew at a compound annual growth rate of approximately 6.5% for the 10 years ended December 31, 2019.9
Looking forward, financial conditions that negatively affected overall growth for small-cap stocks in 2019 appear to be easing. As we mentioned above, we are starting to see a pickup in US manufacturing due to the resolution of trade tensions. In addition, the Treasury yield curve is steepening a little after flattening in 2019 and weighing on the performance of financial stocks in the Russell 2000 Value Index.10
If these financial conditions continue to improve, they could become tailwinds for growth in the next year or so.
Reason #4: Large Opportunity Set
Compared to large-cap stocks, small caps often have very little analyst coverage, as the chart below shows. What this means is that we need to turn over rocks to find value among the thousands of companies in the small-cap universe, which includes industries ranging from aerospace to semiconductor capital equipment.
Our team constantly meets with companies, researching them to find potential investment candidates among the small-cap universe. Our approach as a group is to invest in businesses that have a track record of success, with shareholder-friendly governance and low leverage, which are trading at what we think are low prices relative to their earnings potential.
In our view, improving US economic growth, combined with weak sentiment reflected in low valuations, could present a nice setup for small-cap stocks for the next couple of years.
Reason #5: Small Caps Can Be Attractive Acquisition Targets
Since 2010, there have been about 140 merger-and-acquisition (M&A) deals announced per year in the Russell 2000 Index, with an average premium of around 30%, as the chart below shows.
In our experience, small-cap stocks can be attractive acquisition targets for a couple of reasons. Smaller companies tend to be more focused on specific end markets than larger companies, and it can be easier for a larger company to buy a smaller company in a certain niche where they’d like to grow than for the larger company to enter the business from scratch.
Potential Risks to Our Outlook
Despite our overall optimistic view on the outlook for small-cap value stocks, we constantly focus on the downside risk. There is a possibility we won’t see a rebound in US manufacturing, the yield curve may flatten or an unexpected shock (such as the recent Novel Coronavirus outbreak) could slow down growth.
While we try to understand what’s going on in the world, we admit it’s possible that things don’t unfold the way we think they will. But we’re hopeful that our process helps us shepherd through the difficult times.
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What Are the Risks?
Franklin Small Cap Value Fund
All investments involve risks, including possible loss of principal. The fund’s investments in smaller-company stocks carry special risks as such stocks have historically exhibited greater price volatility than larger-company stocks, particularly over the short term. Value securities may not increase in price as anticipated or may decline further in value. Additionally, smaller companies often have relatively small revenues, limited product lines and a small market share. In addition, the fund may invest up to 25% of its total assets in foreign securities, which involve special risks, including currency fluctuations and economic and political uncertainty. REITs may be affected by any change in the value of the properties owned and other factors, and their prices tend to go up and down. These and other risks are detailed in the fund’s prospectus.
Investors should carefully consider a fund’s investment goals, risks, sales charges and expenses before investing. Download a prospectus, which contains this and other information. Please carefully read a prospectus before you invest or send money.
1. We define small-cap companies as those with market caps not exceeding either: the highest market cap in the Russell 2000 Index; or the 12-month average of the highest market cap in the Russell 2000 Index.
2. The price-to-earnings ratio, or P/E ratio, is an equity valuation multiple defined as market price per share divided by annual earnings per share. For an index, the P/E ratio is the weighted average of the P/E ratios of all the stocks in the index. Indexes are unmanaged and one cannot directly invest in an index. They do not include fees, expenses or sales charges. Past performance is not an indicator or guarantee of future results.
3. Source: Russell Indices. Value stocks represented by the Russell 2000 Value Index. Indexes are unmanaged and one cannot directly invest in them. They do not include fees, expenses and sales charges. Past performance is not an indicator or guarantee of future performance. Additional data provider information available at www.franklintempletondatasources.com
4. Past performance is not an indicator or guarantee of future results.
5. Source: Institute for Supply Management, February 3, 2020. The US Manufacturing Purchasing Managers’ Index (PMI) measures the activity level of purchasing managers in the manufacturing sector. A reading above 50 indicates that the sector is generally expanding; below 50 indicates that it is generally declining.
6. Past performance is not an indicator or guarantee of future results.
7. The USMCA is a free trade agreement between Canada, Mexico and the United States. As of February 13, 2019, it has been ratified by each country except Canada.
8. Sources: FactSet, MSCI, NBER, Franklin Templeton’s Global Research Library. MSCI makes no warranties and shall have no liability with respect to any MSCI data reproduced herein. No further redistribution or use is permitted. This report is not prepared or endorsed by MSCI. Important data provider notices and terms available at www.franklintempletondatasources.com.
9. Sources: Bloomberg, Russell. Frank Russell Company is the source and owner of the trademarks, service marks and copyrights related to the Russell Indexes. Russell® is a trademark of Frank Russell Company. Indexes are unmanaged, and one cannot invest directly in an index. They do not reflect any fees, expenses or sales charges. Important data provider notices and terms available at www.franklintempletondatasources.com.