John Husselbee

Revisiting value and small caps

John Husselbee

I saw a cartoon recently with a genie outlining three rules to his new master: no wishing for anyone’s death, no making people fall in love and no bringing back the dead. The master’s first wish was for value to outperform, to which the genie replied: ‘There are four rules’.

Value investors could be forgiven for believing the universe is against them at this kind of cosmic level over recent years, particularly with the stratospheric rise in US technology stocks. But for anyone fearing another ‘what might spark a value recovery’ article, we are not planning to do that here, or at least not just that; indeed, many value managers have admitted that hoping for particular catalysts to drive a renaissance is likely to be fruitless at this stage.

Saying that, we wrote earlier this year about several short-term performance drivers running contrary to longer-term trends, and with recent spells of stronger returns for value and an apparent reappearance of the small-cap premium (as well as tech stocks taking a hit), this remains a topic worthy of investigation.

To recap, there are clear trends in evidence over the last five years and any portfolios getting these right will have comfortably outperformed. In equities, the US has substantially outstripped other markets around the world, including the supposedly higher risk (and higher reward) emerging markets. Another pronounced trend has been growth outperforming value (more than tripling the returns) and a third is large cap companies beating small.

All three are against longer-term trends and have created a generally tougher backdrop for active management, for which value and small-cap outperformance have typically been tailwinds. The question for asset allocators looking forward, especially in the wake of Covid-19 disruption, is whether the last five-year period is cyclical or secular: have conditions changed to favour these factors in the future or will longer-term trends reassert themselves?

As stated, even the staunchest value advocates are not expecting some kind of switch to be flicked in favour of their style; what we are seeing, however, is growing debate about how long the incredible run of US technology giants can continue and this will certainly pick up in the wake of a spell of weakness and profit taking in recent weeks. It could be argued the rise of the FAANGs (Facebook, Amazon, Apple, Netflix and Google) and Microsoft is behind all three short-term trends, and 20 years after the last tech bubble burst there are some parallels emerging.

Several interesting data points are available on the massive skew in US equities at present, with the top 1% of companies in the S&P 500 accounting for a record 22% of its market cap, versus 18% at the peak of the last tech bubble and a 14% average since 1980. Tech advocates would highlight a key difference compared with the situation in 1999, namely that these stocks do have revenues that can, at least partly, explain their valuations. But there are clearly two markets operating in the US: a small group of stocks large enough to drive index level performance on their own and a multitude of smaller companies still battered by coronavirus headwinds. And for our part, we go back to the old proverb that trees cannot grow to the sky.

RWC’s John Teahan (whose Enhanced Income Fund is held in our Income portfolios) recently posted a great piece on the tech question, examining it through the lens of Amazon. This is a stock that has produced compound annual growth of 39% since its IPO in 1997 and encapsulates that inflated influence on market returns effect: over 10 years to end of March, Amazon has contributed 3% of the 100% return from the MSCI World Index versus the average stock’s 0.04%.

In terms of valuation, the company is trading on a massive historic P/E ratio of over 143 times and 5.1 times price to sales, and the question is obviously whether such phenomenal growth can continue. As a value advocate, it is little surprise to find Teahan concluding he would rather watch Amazon from the sidelines, citing headwinds including growing competition, a saturated market for Prime customers in the US and political challenges whoever ends up in the White House.

Value basically needs three things to enjoy better fortunes: an improving economy and some inflation, rising bond yields (which typically signify improving growth) and some kind of shift in the current power balance between tech (growth) and financials (value). Against an improving economic backdrop, investors are less willing to pay up for growth but while value has benefited from something of a recovery sugar rush over the last couple of months, few economists are predicting anything other than continued lows in inflation, growth and interest rates for the forseeable future.

When discussing the value/growth dynamic, however, most people overlook the fact that this increasingly historic disparity has been driven not by earnings but by ongoing re-rating, and current valuations suggest this cannot go on forever. We have continued to stress that, while the last decade has been challenging for value investors, the style is neither dead-nor-defunct: how can looking to buy cheaper assets ever be ‘dead’? There is a larger than normal opportunity for value investors today if they are patient but no one can say exactly when this will bear fruit.


As an interesting sidebar, new research from Style Analytics also rejects the value is dead argument but suggests it is stuck in the past and weighed down by its legacy of Benjamin Graham and Fama and French. These academics connected value to a company’s price to book ratio but this new analysis claims an updated definition is needed, focusing more on research and development (R&D) and ‘intangible’ assets. Style Analytics settled on free cash flow yield as a new measure of ‘value’, the amount of cash a company generates that can be used to pay back shareholders after servicing debt and capital spending, divided by its share price, claiming this has a much stronger chance of outperformance.

Over recent years, there has been a similar, albeit less pronounced, dip in small cap performance, with these companies typically at the heart of economic and market growth and therefore of active outpeformance overshadowed by index-dominating behemoths. Again, times may be changing and many are expecting small caps to fulfil their traditional role in leading markets out of recession. The first 12 months of a new bull market following an economic downturn have historically involved significant outperformance by smaller companies and there have been some encouraging early signs in recent weeks.

To be clear, we are not suggesting huge shifts in favour of value or small caps but in an environment in which large-cap growth looks priced to perfection, any reversion towards longer-term means can be an opportunity for investors.

We continue to believe longer-term outperformance trends in terms of value versus growth, emerging markets versus the US and small caps versus large can re-emerge. While limited, the short runs for value and smaller companies in recent weeks show how quickly things can turn and we maintain that portfolios able to tilt between these while ultimately keeping a foot in both camps offer a compelling and diversified risk/reward balance.

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Tuesday, September 15, 2020, 10:58 AM