• 1879 Advisors

Is there a place for small-cap value?

- 8/10/20 Market Notes -

By Eric M. Rossman, Senior Portfolio Analyst

The first week of August ended higher with the S&P 500 and Dow ending slightly positive Friday to extend their streak to six days. The bottom three performing sectors of the year led the week with Industrials up 4.76%, Financials up 3.27%, and Energy up 3.12%. As for the Indexes, the S&P 500 was up 2.45%, the Dow was up 3.8%, and the Nasdaq ended up 2.47% for the week. The US added 1.763 million jobs in July topping expectations of 1.4 million and the unemployment rate was also better than expected, falling to 10.2%. Talks between the White House and Democratic leaders for a new coronavirus stimulus package fell apart Friday. However, over the weekend the President signed four executive orders to extend unemployment benefits, provide a payroll tax holiday, defer student loan payments through 2020, and extend the federal moratorium on evictions. Congress controls federal funding so these orders could face a legal battle.

Futures this morning are mixed. This week will include economic releases on inflations, July retail sales, and consumer sentiment.

Is there a place for small-cap value?

Growth stocks have significantly outperformed value stocks this year, while large-caps have outpaced small. It is no surprise, then, that small-cap value has been the worst performing asset class year to date, continuing the trend of the last 5 years. What accounts for this persistent underperformance and is there a place for small-cap value in a portfolio?

Small-cap value stocks are usually more economically vulnerable, more volatile, and more cyclical than other asset classes which greatly reduce their financial flexibility during hard economic times. Looking through broad category labels shows that the small-cap value segment is concentrated in financials, industrials, real estate and energy. These volatile sectors make up more than half the index. These sectors are economically cyclical businesses and small-cap value companies tend to be capital intensive, more leveraged and less profitable than companies in other sectors.

While lockdowns resulting from the global pandemic have greatly impacted businesses of all types, small-cap value companies have seen large revenue declines, operating losses, negative free cash flow and an increase in leverage. The lack of free cash flow means many companies have had to reduce or eliminate dividends any they are unable to invest in their businesses, undertake M&A and are reliant on debt to fund operations. This is a scenario where solvency is called into question and we have, in fact, seen a large uptick in corporate bankruptcies.

Does this asset class bring any positives? At some point, it is possible that we could see a rotation into value stocks as growth stocks have become crowded. These names have the potential for large upside moves in the event of economic recovery. Small value stocks have been underperforming for so long that valuations are well below historical averages and the sector could see valuation expansion that would magnify earnings gains in an improved economic environment. The best case scenario for small- cap value stocks would be a short recession leading to a sharp recovery. The problem is that there are a lot of outside factors that could derail that recovery and many companies are hobbled by declining revenue and higher debt levels of the current slowdown. If the pandemic persists for long it could permanently change the business landscape and impact small value companies for even longer.

Given our dim view of the asset class, we moved out of small-cap value in mid- March. While we continue to monitor developments, we believe better opportunities exist elsewhere.

Disclosures: This market commentary is written by the 1879 Advisors® and represents the views of 1879 Advisors®. This commentary is not investment advice and should not be used as a basis to make investment decisions. Please consult with your registered investment advisor before making any investment decisions.

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