Asking a small-cap specialist "Is it a good time to invest in small-cap?" may sound to some like the old joke about asking a barber if you need a haircut. With that point taken, we would suggest that as long-time residents of small-cap land, we have gleaned a few insights and recognized a few signals that reveal when conditions look favorable for above average returns for small-cap stocks. From our perspective, three of those signals are currently flashing green.
First, we looked at the experience of small-caps since 1945—a 75-year period—with a particular focus on the aftermath of steep market declines in order to see what patterns emerged. The most recent is the 17th decline of 15% or more in small-caps since the end of 1945. The average peak to trough decline of the 16 previous episodes was 30.3%. In every one of these downturns, small-caps recovered to the prior peak, taking on average 11.7 months from the low point to fully recover, though there was wide variation in the recovery period length from cycle to cycle.
CRSP 6-10 Market Cycles After 15% Drawdown
Monthly Data from 12/31/45 through 8/31/20
Past performance is no guarantee of future results. Historical market trends are not necessarily indicative of future market movements.
We have always held the view that time is one of the least consistent parameters in investing, so we simply cannot know how long a recovery will take. But while the timing is variable, there has been a consistent pattern over the past 75 years. Declines were followed by recoveries, and then a new peak was reached. Most striking to us was the fact that small-cap's new peaks had a median of 55% above the prior peak. Of course, this historical market cycle pattern does not guarantee a new high for small-caps. Yet with the asset class roughly 5% below its prior peak as of this writing, our view is that this bull market will not end till we see a much higher peak for small-cap stocks.
Second, there are a number of elements, many of them counterintuitive, that make up a successful investor. One of the most salient is that upside opportunity may increase after a subpar experience. As humans, we are wired to extrapolate and to expect existing trends to continue. But this expectation can lead us astray, as markets are cyclical and have a tendency towards regression to the mean. There are exceptions –industries undergo secular declines; trends can persist for years. Energy stocks, to take a current example, have underperformed for at least a decade, as have banks. Betting on either to reverse has been more like Waiting for Godot than All's Well That Ends Well.
Still, we think that a multi-year period of significantly below average returns for the broad and diverse small-cap universe is more than likely to be followed by a period of significantly above average returns. And we have just completed one of those below average return periods. For the three years ended 9/30/20, the Russell 2000 Index returned only 1.8% annualized, compared with a 10.1% average advance for all rolling monthly three-year periods since the index's 12/31/1978 inception. We looked to see how often small-cap investors have seen "3 under 3": three-year periods with return of 3% or lower. That's only happened in 14% of all three-year periods over the past 40 years. Even more important, the average subsequent three-year annualized return was 17% following these "3 under 3" periods.
When 3-Year Return was <3%, What Was Subsequent 3-Year Return?
From Russell 2000 Inception (12/31/78) through 9/30/20
Past performance is no guarantee of future results.
Does this historical pattern ensure that these terrific returns are predestined? No. Yet we do think it's likely that the most recent subpar return period will be followed by an above average return period.
Finally, market valuations are a topic of intense disagreement and debate among investors. We bring two less frequently used tools to this analysis, tools that suggest, at least to us, that small-caps are undervalued, even significantly so. While the Financial Crisis wrought many changes in the world, two shifts related to valuations stand out. First has been a transition to more "asset-light" economies and business models. This transition has made a subtle though profound impact on the economics of asset light businesses. Because there are fewer physical assets, companies need less ongoing investment (or capital expenditure), so each dollar of profit has led to more free cash flow.
Analysts who have focused only on companies' earnings have missed this transition. Similarly, investors who use P/E instead of free cash flow measures have missed the growing attractiveness of these asset light businesses. In our view, they have been too cautious over the past several years. Small-cap's free cash flow growth over the last several years has been much stronger than its profit growth. If we measure the five-year period ended 12/31/19, before the distorting effect of this year's recession, free cash flow for the Russell 2000 Index grew by 118% compared with only 3% growth in EBIT (earnings before interest and taxes) over the five-year period beginning on 12/31/14.
The second change affecting valuations has been the precipitous decline in interest rates. While one could view that this trend began in 1981, interest rates have been lower in recent years than most professionals have seen over the course of their entire careers. However, many equity investors have not adapted their valuation tools to account for these lower rates. We think this omission has fostered misleading conclusions.
We take the classic Finance 101 view that a company is worth its future free cash flows discounted at some rate back to the present. As we are now experiencing some of the lowest rates on record, it would support among the highest valuations well. To evaluate current small-cap valuations by taking ultra-low interest rates into account, we use the equity risk premium, whereby we subtract the free cash flow yield (free cash flow divided by enterprise value) from the U.S. 10-year Treasury Yield. A higher number is preferable because it indicates the potential extra return "risk premium" that the market is offering for small-caps compared with Treasuries. The small-cap equity risk premium at the end of September was greater than 1%. While that number may sound small, the historic returns from periods when the equity risk premium was 1% or more have been anything but. When the equity risk premium was 1% or greater over the past 20 years, the subsequent average one-year return was 21%.
Historically High Equity Risk Premium Has Led to High Returns
Average Subsequent Russell 2000 1-Year Performance in Equity Risk Premium Ranges1 from 9/30/00 to 9/30/20
1 Equity Risk Premium = Latest Twelve Months Free Cash Flow divided by Enterprise Value minus 10-Year Treasury Yield. Source: FactSet.
Past performance is no guarantee of future results.
Do past patterns of market cycles, recent subpar small-cap returns, and higher than average equity risk premiums provide small cap investors with assurance that better days are ahead? They do not. As always, past performance is no guarantee of future results. All that we can offer as experienced small cap investors is to identify, based on past patterns, when we think that probabilities are indicating that it's a good time to invest in small-caps. As we are doing now.
Important Disclosure Information
Mr. Lipper's thoughts and opinions concerning the stock market are solely their own and, of course, there can be no assurance with regard to future market movements. No assurance can be given that the past performance trends as outlined above will continue in the future.
The performance data and trends outlined in this presentation are presented for illustrative purposes only. Past performance is no guarantee of future results. Historical market trends are not necessarily indicative of future market movements.
