- Chip Rewey
The Law of Small Numbers
We believe the outlook for small cap value for 2022 and beyond is compelling, both in an absolute sense and relative to the larger and growthier indices.
1. Valuation: As seen in the table below, small and value factors are cheaper than the large and growth factors. In our view the differences are compelling, not only in potential upside returns into a stronger economy, but also downside risk management which we believe has been an under rated factor for investors over the last decade.
2. Strengthening Economy: We believe the strengthening of the economy is very favorable for the small cap value sectors. GDP growth should drive higher revenues for domestic producers, leading to positive margin leverage and increased earnings. We believe small cap industrials will show strong results through 2022 as they deliver on strong backlogs and rebuild depleted customer inventories. Additionally, the supply shocks, in our view, demonstrate that the Just-In-Time manufacturing philosophy has gone Just-Too-Far, and companies will rebuild domestic manufacturing and sourcing capabilities, most likely benefitting small cap U.S. industrials for the next few years.
3. Higher Interest Rates Currently Help Financials: Low interest rates have negatively impacted the earnings of financial companies. As a result of the post financial crisis reforms (which are positive in our opinion) banks and insurance companies have had to substantially raise the level of capital they retain against liabilities. As rates fell, the ability for financial companies to earn spread income on their capital evaporated. Thus, we see most financials as well capitalized “piggy banks” that are tremendously under-earning. As rates rise, spread income is highly likely to rise as well, driving earnings growth. The small cap value indices should benefit from this move, due to their relatively high weighting of financial companies.
4. Moderate Inflation Good For Small Caps: We believe moderate inflation is actually a good thing for small cap industrials as well as good for distributors as a whole. Moderate inflation means that producers and distributors are more likely able to push through price increases to their end customers. Once the paradigm of buyers accepting a price increase is set, in contrast to the deflationary pressures of the last few years, producers and distributors should be able to push through cost increases plus margin increases, i.e. increase their profitability through price.
Bad Math for Large Growth
One of our favorite investing idioms is the question “Are you investing for Return on Capital, or Return of Capital?” We believe this question sums up our view of the poor investment paradigm for large and growth sectors. As the table above illustrates, the valuations for large and growth factors seem stretched. At best, we see an environment where elevated future earnings expectations are met, and these companies grow into their valuations and thus suffer multiple contraction, leaving little room for share price increases, i.e. a best case of return of capital.
However, in our view, the large growth group is extremely vulnerable to share price decreases, as the decade long era of low interest rates comes to an end. We believe, most large cap investors rely on a discounted cash flow (DCF) framework when valuing securities, where a 10-year earning stream and an assumed terminal value for the out years are discounted (divided) by an adjusted interest rate (weighted average cost of capital, or WACC). As the Fed continues to taper and eventually raise interest rates, the WACC will most likely rise, which would reduce the net present value, or price target, imputed by a DCF calculation. In our view, growth and momentum investors have misapplied low and falling interest rates to valuations for the last decade, and as the era of low rates ends, the frothy valuations of large cap growth look vulnerable.
The Law of Small Numbers:
If the factors we discussed above come to fruition, the implication for small cap value outperformance seems to be compelling. We list the cumulative market value of the S&P500, as well as the Russell 2500 Value and Russell 2000 Value in the table below:
The last column illustrates what we are referring to as the “Law of Small Numbers,” that is that a 1% weight of the total market cap of the S&P 500 equates to a 7.5% weight of the Russell 2500 Value and a whopping 19.1% of the Russell 2000 Value. Thus, if investors embrace our view, and decide to rotate a mere 1% of their S&P 500 holdings to small and mid-value, the moves higher in these indices could be dramatic. When value investors advocate buying ‘ahead of the herd,’ this is an example of what we are talking about.
This material is for informational purposes only and is not a recommendation or advice. Investments and strategies mentioned are not suitable for all investors. Opinions are based on current market conditions and are subject to change. No one can predict or project performance, and forward-looking statements are not guarantees. Past performance is not indicative of future results. Investing involves risk, including the loss of principal. Indices are unmanaged and you cannot invest directly in an index.