Everyone loves a good tag sale. Finding that hidden treasure that’s being cast away, or otherwise seeing value where others cannot, appeals to the human condition. Investors focused on the small cap growth style box can probably relate right now. Through the first three quarters of 2021, investors have seemingly cast aside small growth stocks in favor of their larger and more-established growth counterparts. For whatever reason, it appears that investors are ignoring the fundamentals and long-term potential of many small, dynamic and fast-growing companies. Does this spell opportunity?

First, the facts: Small-cap growth (as measured by the Russell 2000 Growth Index) has been a material underperformer versus large-cap growth (as measured by the Russell 1000 Growth Index), trailing in year-to-date returns by approximately 15% as of mid-September 2021. In recent months, many innovative large-cap growth stocks have bounced back relative to those cyclical large-cap value stocks that initially rebounded more quickly as we came to terms with this pandemic in late 2020. 

Yet there has been no similar bounce among small-cap growth stocks, which continue to lag their small-cap value counterparts. The dislocation between what we believe are comparably strong fundamentals and returns remains wide, and there has been an almost 20% performance gap between small growth and small value (measured by the Russell 2000 Value Index) year-to-date through mid-September. This drives our view that small growth as an asset class appears attractive, and we continue to see strong underlying fundamentals in many small secular growth stocks. Importantly, our work also suggests that  small-cap growth investors need not be anxious in the face of rising rates. 

Digging deeper within the Russell 2000 Growth Index, there’s been an interesting divergence between what we call “cyclical” and “secular” growth companies. Lower-growth cyclical companies (defined as those more dependent on underlying economic growth and in the chart below as stocks with expected long-term growth of less than 20%) have outperformed higher-growth secular companies (defined as those poised to grow earnings more rapidly through innovation and by taking market share and in the chart below as stocks with expected long-term growth of more than 20%). This leadership change within the Russell 2000 Growth Index has been especially pronounced as the sectors that had lagged during the start of the pandemic have more recently driven the market higher, including consumer discretionary, producer durables, energy, and materials processing sectors. Meanwhile secular-oriented sectors, including health care and technology where many disruptive companies with long-term growth potential operate, have lagged. 

What’s the takeaway for investors? The result of this recent performance and leadership change is that small growth stocks—and particularly small secular-oriented growth—are trading at a substantial discount to both small value stocks and large growth stocks. As ever, there are buyers and sellers, and one person’s trash is another’s treasure. Thus, we believe the recent period of small-cap growth underperformance is a manifestation of temporary market dislocations that savvy investors can act upon. 

For context, consider that the forward P/E ratio of small growth companies (excluding those companies that do not yet have earnings) stands at more than a 25% discount relative to those large-cap companies in the Russell 1000 Growth Index. That is even more intriguing given that historically (over the past 20 years), investors would have to pay a slight premium on average to capture the exciting potential of small-cap growth companies.

It’s an upside-down world right now. Given that many large-cap indices now trade at a substantial premium to their history, the small growth style box merits consideration for new allocations. And specifically within small growth, we believe that favoring secular growth names and sectors looks particularly attractive.