The October market rout was particularly unforgiving for most large-cap stock funds. Most stock funds fell an average of 7.9%, a plunge that eradicated all the 2018 gains accrued. Indeed, the damage done to all stock funds put the total return of all U.S. mutual stock funds and ETFs at an embarrassing 0.0%, according to data from Lipper.
Compared to the pummeling large caps endured, small caps escaped relatively unscathed. Consider the stark contrast in the numbers. Although the small-cap sector was not spared, small-cap growth funds lost only 11.8% for a net gain for the year of 6.5% — a decline large caps would have considered enviable. During the first eight months of the year, the S&P 500 index logged a gain of 8.5%, while the Russell 2000 rose 13.4%.
When contrasted with the carnage visited upon large stock funds, small-cap losses can only be described as benign. The smaller percentage losses stem from the fact that small-cap stocks started their decline from a position with oversized gains.
The small-cap sector began its upwards trajectory shortly after the 2016 election. Tax cuts and a lifting of the regulatory burden benefited small corporations. These two factors have had a salutary effect on the profitability of smaller companies, spurring rapid and unimpeded earnings growth. The elimination of costly and cumbersome regulations benefited smaller corporations disproportionately relative to its more muted impact on larger companies.
Despite the impressive returns relative to the S&P 500 and minimal post-October losses, there are some omens that could bode ill for the small-cap sector going forward. The flip side of the lower percentage losses coin is that small caps have declined further than their larger counterparts during the post-Labor Day sell-off. As of Oct. 31, The Russell 2000 has dropped 13.2% from its Aug. 31 high. The S&P 500 has dropped only 5.5%. While small-caps still have a cushion, they are now in correction territory and value investors should be cautious.
The trick for small-cap investors is they need to be more selective. Part of the reason for the rapid rise in small caps was the belief that the tax cuts would produce earnings growth that overshadowed companies in the S&P 500. Additionally, in general, the exposure to the fallout from a trade war was viewed as minimal on small-cap companies, as most of them received very little of their revenue from operations outside of the country.
Looking back now, this may have been an overly optimistic forecast, as some smaller corporations are suppliers to the large companies who in turn are vulnerable to the trade war with China.
Although these risk factors may have been present at the start of the late 2016 rally, they were initially dismissed, but now have a more significant impact on the sector, as valuations have now outpaced the known risks. As small-cap valuations continued their unbroken rise, other factors now were viewed as problematic and could no longer be ignored, such as the level of debt carried by many smaller companies and the impact this has on Ebitda.
Other worrisome signs started to emerge as well, indicative of a rally that was now overheating with unsustainable and irrational valuations. For the first eight months of the year, some fund managers and analysts noted that approximately 35% of Russell 2000 corporations generated no earnings. Nonetheless, some of these same stocks jumped over 22%, while companies turning profits rose only 12.6%. A similar discrepancy occurred between companies paying dividends and those that did not.
Currently, the market favors companies that have a sufficient earnings surplus to pay dividends. These stocks, while depressed along with the rest of the market, have been affected less than lower-quality stocks. That is precisely the selective, individual stock picking approach that Amy Zhang’s Alger Small-cap Focus Fund (AOFIX, Financial) has adopted in the post-October environment. The performance figures for the fund strongly support the viability and utility of the principles of value investing.
At the end of the quarter, the fund had a 44.8% year-to-date gain. While that return was trimmed to 25.7% after the market tumult in October, the fund still outperforms large-cap stocks as well as the small-cap growth group of funds tracked by Morningstar. The fund seeks only companies that have solid fundamentals and have been in business for 20 years or longer.
As interest rates continue to climb and the duration of the long-running bull market unknown, the watchword for intelligent investor is vigilance and prudence, particularly in a downward trending market that is increasingly volatile.
I have no position in any of the securities referenced in this article.
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