Tuesday, October 7th, 2014

Value Not Growth in Small Caps

While watching to the FT’s preview of the US earnings season, we were confronted with one of the great misconceptions of modern investing. The interviewer turned to camera and said that US Small Caps should benefit from the superior performance of the US economy and that the strong dollar was good for them relative to large caps because they would not suffer the same percentage drag on earnings. The idea that Small Caps outperform when the economy grows fast, sounds eminently plausible. It’s the sort of logical deduction we would like to believe in. Unfortunately it is wrong.

The first and most obvious point is that it assumes a direct relationship between earnings growth and share price performance which we would not assume for a sector like Financials or Industrials. Stock market performance bears only a tangential relationship to what is happening in the real economy and Small Caps are no exception to this rule.

The second point is that it is clearly not working at the moment. US Small Caps are ranked #11 (out of 11) in our expanded sector model. The last time they were in first place was in November 2013. They started 2014 in third place and by the beginning of May they had fallen into the bottom three places. They have been continuously last since July. Our model selects sectors on the basis of risk-adjusted relative total return, so it is impossible for a sector which is outperforming to be ranked in the bottom part of the table.

Reviewing 2014 to date, we notice that small cap underperformance really dates from the time when it became apparent that the weather-induced weakness in Q1 GDP had not carried on into Q2, and that there would be no need for the Fed to pause the taper or put back the timetable for interest rate rises. This is quite a common occurrence. Small Caps actually react badly to the threat of rising interest rates. We are not big fans of discounted cashflow as a valuation tool, but the simplest way to think of this is to argue that a high beta sector like Small Caps will be more affected by a rise in the risk-free rate that other sectors or styles. We see exactly the same dynamic in the UK, where interest rises are also expected.

Small Cap outperformance most frequently occurs when interest rates are falling (or monetary policy is eased) and the stock market is anticipating a recovery in earnings. Our US sector model was consistently overweight (or at least above neutral) on Small Caps from March 2009 through to June 2011. The first big underweight of this cycle was a direct result of the taper tantrum in May 2012.

In general we notice a good relationship between the peaks and troughs of the small cap and the value styles. The correlation in between peaks and troughs is not particularly powerful, but the peaks and troughs have tended to coincide from the beginning of 2008 onwards (with an exception in late 2013).

We do not think that there is likely to be any change to this pattern in the near future. With technology and healthcare at the top of the sector rankings we have a bias towards growth which is entirely consistent with an underweight on Small Caps. If the Fed does not start raising rates till the middle of 2015, it is quite possible that Small Caps could underperform for many more months.

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