A Value Investor’s View on US Small-Cap Stocks

Five reasons why small-cap value stocks could perform well as the US economy continues to recover from the COVID-19 pandemic.

    Steven Raineri

    Steven RaineriVice President, Research Analyst, Portfolio ManagerFranklin Small Cap Value Fund

    Franklin Small Cap Value Fund Portfolio Manager Steve Raineri gives five reasons why he thinks small-capitalization (small-cap) value stocks could perform well as the US economy continues to recover from the COVID-19 pandemic.

    During a broad COVID-19 equity market selloff in March and April, US small-cap stocks were hit particularly hard.At the time, investors seemed especially concerned about how these companies would fare in a US economic slowdown.

    Since then, many small-cap stocks, as represented by the Russell 2000 Index, have rallied from April’s lows as the US government and Federal Reserve’s rapid response to the COVID-19 crisis helped lift markets. Given the index’s most recent performance, some investors have asked us for our views on a potential sustained rally in small-cap stocks.

    Here, we outline five reasons we think small-cap stocks, particularly those with select value characteristics, are worth considering at this time.

    Reason # 1: Compelling Valuations

    As the chart below shows, at the end of August 2020, small-cap value stocks in the Russell 2000 Value Index were trading near their 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

    Relative Price-to-Earnings Ratio

    Relative Price to Earnings: Russell 2000® Value / Russell 1000® Value Index

    12/31/2009–8/31/2020

    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. Past performance is not an indicator or guarantee of future performance.


    We see a few reasons for this difference in valuations, including the belief mentioned above that all small-cap stocks are more susceptible to a US economic downturn. While 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 with higher margins, lower leverage and decent earnings growth.3

    Reason #2: Earnings Growth Potential

    As value investors, we seek to avoid unprofitable and structurally challenged companies, and look for companies with positive earnings growth potential. 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 4.9% for the 10-year period ended August 30, 2020.4

    Earnings Per Share

    Earnings Per Share: Russell 2000® Value vs. Russell 2000® Index

    8/31/2000–8/31/2020

    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. Past performance is not an indicator or guarantee of future performance.


    In addition, our research shows that many of the small-cap value companies we follow performed better during the second-quarter earnings season than analysts expected. As of August 31, 2020, 1,140 companies of the 1,432 companies in the Russell 2000 Value Index reported earnings, with 759 of those 1,140 companies reporting positive earnings surprises for the quarter.5


    Earnings Surprises Rampant Throughout Small Caps

    • 345 of 1,140 holdings (30%) reported greater than 50% positive earnings surprise
    • 160 of 1,140 holdings (15%) reported greater than 100% positive earnings surprise

    Russell 2000 Value Companies with Positive 2Q Earnings Surprises

    Source: FactSet. Russell 2000 Value Index holdings that have reported second-quarter earnings, as of August 31, 2020, as reported by each company. 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.


    Looking forward, analysts project higher 2021 earnings-per-share growth for companies in the Russell 2000 Index than for those in the S&P 500 Index and Nasdaq.6

    Reason #3: Performance During Value Stock Rallies

    According to our analysis of companies in the Russell 1000, 2000 and 3000 indexes, value stocks only outperformed growth stocks 40% of the trading days in the 12 months ended August 31, 2020.7 However, on those days when value stocks outperformed growth, small-cap value stocks outperformed large-cap value 68% of the time.8


    Small Caps Have Benefited When Value Outperforms

    • Value outperformed just 105 of the last 261 business days (40%)
    • 71 of the 105 days (68%) small caps outperformed large

    Source: Morningstar. 12 months, as of August 31, 2020, daily returns. 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. Past performance is not an indicator or guarantee of future performance.


    Reason #4: Performance Over Past 20 Years

    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 August 31, 2020.


    Over the Long Term, Smaller Stocks Offer The Highest Returns

    Cumulative Performance: Value of $1 invested on 12/31/1999

    As of 08/31/2020

    Source: Factset, Russell Investment Group. Russell Investment Group is the source and owner of the trademarks, service marks and copyrights related to the Russell Indexes. Russell® is a trademark of Russell Investment Group, S&P Dow Jones Indices. Slide created by Franklin Templeton’s Global Research Library. Important data provider notices and terms available at www.franklintempletondatasources.com.


    In addition, if you divide the 20-year period into two 10-year periods, our research indicates that $1 invested in small-cap value stocks would have risen in value during both periods, while $1 invested in the S&P 500 Index for the 10 years ending August 31, 2010, would have fallen in value.9


    Over the Long Term, Smaller Stocks Have Offered The Highest Returns

    Sources: FactSet, Russell Investment Group. Russell Investment Group is the source and owner of the trademarks, service marks and copyrights related to the Russell Indexes. Russell® is a trademark of Russell Investment Group, S&P Dow Jones Indices. Important data provider notices and terms available at www.franklintempletondatasources.com. Past performance is not an indicator or guarantee of future performance.

    Reason #5: Potential Acquisition Targets

    From 2010 to 2019, there were about 140 merger-and-acquisition (M&A) deals announced per year within Russell 2000 Index companies, with an average premium of around 30%, as the chart below shows. Although M&A activity has slowed in 2020 due to travel restrictions and other short-term business impairments related to the COVID-19 pandemic, we expect to see activity pick up and return to long-term levels.


    Merger & Acquisition Deals

    M&A Deals* of Companies in Russell 2000® Index

    1/1/2010–9/3/2020

    * Note: Includes M&A, company takeover and majority purchase per Bloomberg.
    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.


    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. In addition, it can be easier for a larger company to buy a smaller company in a certain niche where they would like to grow than for the larger company to enter the business from scratch.

    Investment Implications

    In our view, the market sentiment regarding small-cap value stocks is not as positive as we think it should be. Compared to large-cap stocks, small caps often have very little analyst coverage. This means we need to turn over rocks to find value among the thousands of companies in the small-cap universe, which includes myriad industries ranging from aerospace to semiconductor capital equipment.

    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 long-term earnings potential for reasons that should dissipate over time. For example, as a result of the COVID-19 pandemic, we have made several changes to our portfolio in recent months based on the “stay at home” theme. In addition, we have also reduced our positions in certain stocks due to ongoing trade tensions between the United States and China.

    While we try to understand what’s going on in the world, we know it’s possible that things will not unfold the way we think they will. But we’re hopeful that we are getting closer to improving economic trends and our process helps us shepherd through the difficult times.


    What Are the Risks?

    All investments involve risks, including possible loss of principal. 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.

    ENDNOTES

    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: FactSet, as of August 31, 2020.

    6. Source: Bloomberg, “Small-Cap Stocks Have Stamina to Outperform Big Tech: Macro View,” August 17, 2020.

    7. Source: Morningstar. 12 months, as of August 31, 2020, daily returns.

    8. Ibid.

    9. Sources: FactSet, Russell Investment Group. Russell Investment Group is the source and owner of the trademarks, service marks and copyrights related to the Russell Indexes. Russell® is a trademark of Russell Investment Group, S&P Dow Jones Indices. Important data provider notices and terms available at www.franklintempletondatasources.com. Past performance is not an indicator or guarantee of future performance.