BRIAN JACOBS, CFA 16-Apr-2020
Let’s be honest. It’s hard to give a proper market outlook when we are in such uncharted territory. The current macro backdrop remains fluid at best, with outsized volatility and challenging credit conditions. This is ushering in an unprecedented monetary response from the Federal Reserve, along with an enormous stimulative fiscal package. Will it be enough to minimize the pain and depth of the pullback? And when will the markets return to some sense of normalcy?
These are tough questions to answer and nobody really knows. Yet one thing that appears certain is that this environment should be ideal for an active equities manager. For starters, the economic and business impact of the coronavirus is becoming clearer as this crisis continues, and there will be “haves” and “have-nots” in the aftermath. There are pockets of the economy that appear materially better off than others given the ability of workers to remain productive remotely, and demand has remained strong for products and services that facilitate this. In addition, companies have varying abilities to service their obligations (companies with higher debt, for example, may be eschewed for longer in this environment). In general, we believe technology-oriented companies are better positioned to endure, while those dependent on global growth or focused on the consumer in places where individuals would need to congregate will be slower to recover. Materials and processing, producer durables, and consumer discretionary (mainly leisure companies) are just a few areas that appear more vulnerable.
Although it may seem counterintuitive, small-cap companies are another area piquing our interest. After the tumult of the first quarter, valuations appear attractive for all U.S. equity styles but especially for small caps. The relative valuation of smaller-cap growth companies versus their large-cap counterparts has widened to levels not seen in 30 years, as measured by forward price-to-earnings. Meanwhile, consensus expectations for long-term earnings growth among small-cap companies remains higher than large-caps over the next three-to-five years. This seems to be a favorable backdrop for a long-term allocation.
Perhaps even more interesting is the fact that small caps have materially outperformed in absolute terms and relative to large caps in the periods following a sell-off, as defined by a period of which each respective small cap and large cap index has fallen below its 12-month moving average (and also where we currently stood, as of early April).
Periods of tumult are when active managers can showcase their risk management protocols. And when sentiment—as opposed to fundamentals—becomes the primary market-moving driving force, opportunities are sure to abound. In this environment there seems to a better way for small cap investors to allocate rather than buying every name in an index.