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-
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March 2002 Fe .2003 Fe . 2020 March2020 off were both alarming and elevated relative to history, Oct. 200 March200 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. 0 Net debt/EBITDA last 12 months to large-cap aluations 0. 0
Small-cap aluations relati e ast relati e aluation: 0. Russell 2000 Index (small caps) S P 00 Index (large caps) 0. 0 4. A erage relati e aluation (1.0 ) 4.0 3. 3.0
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31 2010 2.0 1. 1.0 Sources: WFAM and FactSet 0. 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
31 2020
31 12 2012 31 12 201 31 12 2013 31 12 200 30 12 201 31 12 2014 31 12 2010 31 12 200 31 12 201 31 12 201 30 12 2011 31 12 200 30 12 200 31 12 2004 31 12 2003 31 12 2001 31 12 200 31 12 201 31 12 1 31 12 2002 31 12 2000 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 0 3 been tepid since the financial crisis. Factoring in the sharp 0 2 drawdown in February and March along with the market 0 strength in April and May, the underperformance of small 0 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
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March 200 Sept. 200 Sources: WFAM and Jefferies Group LLC 1,000,000,000 2 , ,2 3 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 discussing for the past few years: software as a service (SaaS), cloud services, online retail, digital payments, the Sept. 1 4 Sept. 1 0 Sept. 1 3 Sept. 1 34 internet of things, and innovation—which we refer to by Sept. 1 Sept. 1 Sept. 2012 March 1 2 March 1 41 March 1 4 March 1 March 1 0 March 1 3 the acronym SCODIi. March 200 March 201 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.
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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. You cannot invest directly in an index. The Ibbotson Associates Stocks, Bonds, Bills, and Inflation (IA SBBI) U.S. Small Cap Index is a capitalization-weighted index designed to measure the performance of the smallest 20 percent of publicly listed equities as ranked by market capitalization. You cannot invest directly in an index. The Ibbotson Associates Stocks, Bonds, Bills, and Inflation (IA SBBI) U.S. Large Cap index is a capitalization-weighted index designed to measure the performance of the largest 20 percent of publicly listed equities as ranked by market capitalization. You cannot invest directly in an index. The views expressed and any forward-looking statements are as of 15 June 2020 and are those of Doug Basile, Senior Portfolio Specialist, and/or Wells Fargo Asset Management. Discussions of individual securities, or the markets generally, are not intended as individual recommendations. Future events or results may vary significantly from those expressed in any forward-looking statements; the views expressed are subject to change at any time in response to changing circumstances in the market. Wells Fargo Asset Management disclaims any obligation to publicly update or revise any views expressed or forward-looking statements. 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