Coronavirus Relief: Economic Recovery and the Vindication of Small Caps
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MARKETING COMMUNICATION | JUNE 2020 Coronavirus relief: Economic recovery and the vindication of small caps By: Doug Basile, Senior Portfolio Specialist Heritage Growth Equity team, WFAM Over the past several months, the coronavirus pandemic Figure 1: 10 worst small-cap bear markets has weakened the global economy, wreaking havoc on Russell 2000 Index: Peak-to-trough decline markets around the globe. While most asset classes were 0 not impervious to the laconic drawdowns in the first quarter of 2020, small-cap stocks were hit particularly -10 hard. The Russell 2000® Index, composed of small-cap -20 stocks, set a record for the quickest descent into bear- -24 -2 market territory, taking only 12 trading sessions to drop -30 -2 -2 -2 -2 -34 20% from its February peak. -40 Percent -41 -0 During its peak-to-trough decline from 19 February -4 -1 -4 through 18 March, the Russell 2000 Index fell 41% while -0 the large-cap S&P 500 Index declined by 35% over roughly the same period. The RVX, a measure of the implied volatility of the Russell 2000 Index, surged to a multiyear high of 83%—its highest level since 2008. Although the speed and amplitude of this recent sell- Jan. 1 1973Jan. Jan. Jan. 1962June 12 Dec. 1968July 10 May 10 1990Oct. Aug.1 1987Oct. Aug. 2018Dec. 201 June 1 1998Aug. April 2011Oct. 2011 March 2002Fe. 2003 Feb. 2020March 2020 off were both alarming and elevated relative to history, Oct. 2007March 200 bear markets are not rare. In fact, since 1962, small-cap Sources: Wells Fargo Asset Management (WFAM) and investors have experienced a 20% correction roughly every Jefferies Group LLC 6 years, on average. Bear market defined as 20% or greater from previous peak Past performance is not a reliable indicator of future results. FOR PROFESSIONAL OR QUALIFIED INVESTOR USE ONLY 1 Small-cap stocks are typically regarded as more risky As the relative outperformance of large-cap stocks persists, relative to large-cap stocks. Their business models the invariable question is whether small-cap stocks are generally are more nascent and are often tied to a single destined to catch up. The answer is largely predicated on product or service, making them more susceptible to the positive changes to economic fundamentals. As key pillars economic cycle. Because their future cash flows can be of the economy recover, like unemployment and consumer more at risk if the economy falters, small-cap companies spending, a positive change in demand can enable small caps typically underperform their large-cap counterparts during to capture the economic improvement more rapidly than bear markets and recessionary periods. large caps. Leverage and liquidity are key reasons this tends to be the This is partly due to the dexterity of small-cap business case. Small-cap stocks generally have higher leverage, lower models. They tend to be able to quickly align a sales profitability, and overall lower credit quality —factors that force or ramp up production to meet increased demand. become exposed as credit spreads widen amid periods of Also, marginal revenue improvements can have a larger market turmoil. As investors tilt their portfolios toward proportional impact on a small company’s financial companies with higher-quality balance sheets, small-cap statement than a larger company’s. Lastly, valuations are stocks often bear the brunt of having weaker balance sheets. very supportive: Small-cap stocks are trading at their lowest levels in 15 years relative to large caps. Lack of liquidity also exacerbates small-cap underperformance during risk-off periods. The same size Figure 3: Small-cap valuations attractive relative to variable that can serve as additional compensation in large caps the form of an illiquidity risk premium for the small-cap Relative price/earnings ratio last 12 months investor is often the same factor that investors lament during periods of stress. As selling pressure increases 1.30 during periods of risk aversion, smaller, less liquid stocks 1.20 experience more downside volatility due to trading frictions. 1.10 Figure 2: Small-cap leverage: Debt/EBITDA 1.00 Leverage has been consistently higher for small caps relative to large caps 0.90 Net debt/EBITDA last 12 months to large-cap aluations 0.80 Small-cap aluations relatie ast relatie aluation: 0. Russell 2000 Index (small caps) SP 00 Index (large caps) 0.70 4.5 Aerage relatie aluation (1.0) 4.0 3.5 3.0 2.5 312011 31201 31201 312013 302012 31200 31201 31201 31200 31200 31200 312014 30201 31200 302020 312010 2.0 1.5 1.0 Sources: WFAM and FactSet 0.5 Past performance is not a reliable indicator of future results. 0 The main factors that led to small caps’ relative underperformance during the downturn earlier this year may be the same ones that could help bolster their performance 312020 31122012 31122015 31122013 31122009 30122016 31122014 31122010 31122008 31122017 31122018 30122011 31122007 30122005 31122004 31122003 31122001 31122006 31122019 31121999 31122002 31122000 as the economy improves and investors become more Sources: WFAM and FactSet comfortable with more leverage and less liquidity. Past performance is not a reliable indicator of future results. EBITDA = Earnings before interest, taxtes, depreciation, Historically, we’ve seen significant recoveries within small- and amortization cap stocks when the economy rebounds. For instance, coming out of recessions, small caps have outperformed large caps in the past 9 out of 10 economic downturns. Moreover, in the six months following each of the past 10 bear markets, small caps have delivered a staggering 37% return, on average. 2 Figure 4: Small-cap bear market recoveries Small caps’ prolonged underperformance over the past Russell 2000 Index: Six-month recovery from bear markets several years could be partly because they’re more leveraged to the economic cycle and economic growth has 80 3 been tepid since the financial crisis. Factoring in the sharp 70 2 drawdown in February and March along with the market 60 strength in April and May, the underperformance of small 50 4 43 caps has become even more exacerbated this year. As of 40 Percent 3 33 May 31, 2020, the Russell 2000 Index had fallen nearly 30 2 20 16% compared with the S&P 500 Index, which had fallen 20 1 10 roughly 5%. 10 0 Nevertheless, even if we factor in 2020’s underperformance, the size premium for small caps has proven to be a worthy risk/reward proposition for investors who have the discipline to maintain a long-term time horizon. March 2020 Figure 5: Hypothetical growth of $10,000 invested in July 10Jan. 11 Jan. 1July 1 Fe. 2003Aug. 2003 Aug. 1Fe. 1 Oct. 10April 11 Oct. 2011April 2012 Oct. 1April 1 Dec. 201June 201 June 12Dec. 12 small caps versus large caps March 200Sept. 200 Sources: WFAM and Jefferies Group LLC $1,000,000,000 2,,23 Bear market defined as 20% or greater from previous peak Past performance is not a reliable indicator of future results. $100,000,000 $10,000,000 Within the small-cap universe, we believe the best 4,322,1 opportunities exist in companies with disruptive business $1,000,000 models that can generate secular growth and compound sustainable growth over extended periods. This recent $100,000 coronavirus period has pulled forward several secular $10,000 trends that have become indelible to many people. Some of these trends are evident within areas we’ve been $1,000 28 41 4 67 0 3 4 0 3 34 discussing for the past few years: software as a service 86 99 1 1 1 1 1 1 1 1 1 1 1 1 2012 (SaaS), cloud services, online retail, digital payments, the 200 201 Sept. Sept. Sept. Sept. internet of things, and innovation—which we refer to by Sept. Sept. Sept. March March March March March March the acronym SCODIi. March March Ibbotson Associates Stocks, Bonds, Bills, and Inflation U.S. Large Cap Index Ibbotson Associates Stocks, Bonds, Bills, and Inflation U.S. Small Cap Index Within SaaS, companies offering critical event- management capabilities are helping people function Sources: WFAM and Morningstar Direct Past performance is not a reliable indicator of future results. through multiple verticals within the work environment. In cloud computing, workload usage has spiked at the enterprise and individual levels as more people vie for storage and bandwidth. Although consumer spending has decelerated overall, online shopping has risen sharply, boosting e-commerce traffic and enabling payment processors and merchant acquirers to benefit from increased digital transactions. Also, digital education via online learning platforms has become ubiquitous throughout the crisis. The internet of things within the semiconductor industry has played an essential role as cloud services usage from areas like gaming have driven demand for more powerful chip hardware. Lastly, within innovation, diagnostics companies have changed their testing methods by setting up mobile stations for patients who would otherwise be unable to receive needed services. We believe these are the types of small-cap companies likely to flourish as the economy recovers. 3 We want to help clients build for successful outcomes, defend portfolios against uncertainty and create long-term financial well-being. l To learn more, contact us at [email protected]. The Russell 2000® Index measures the performance of the 2,000 smallest companies in the Russell 3000® Index, which represents approximately 8% of the total market capitalization of the Russell 3000 Index. You cannot invest directly in an index. The S&P 500 Index consists of 500 stocks chosen for market size, liquidity, and industry group representation. It is a market-value-weighted index with each stock’s weight in the index proportionate to its market value.