US small-cap value stocks have enjoyed considerable success since value stocks began to outperform growth in October 2020. Investors flocked to companies that proved resilient despite having been punished during the pandemic. Even after the recent rally, we believe several forces will continue to drive the recovery in the months, and possibly years, ahead.
Since last October, small-cap value stocks have staged an astounding recovery relative to growth stocks. The Russell 2000 Value Index of smaller value stocks surged by more than 61% over the last two quarters. And the value-growth return gap has widened in the first quarter of 2021: the Russell 2000 Value returned 21.2%, compared to only 4.9% for the Russell 2000 Growth Index (Display). Many investors now wonder whether the small-cap value rally can continue after a winning margin of that magnitude.
We think the answer is an emphatic yes.
What Spurred This Rally?
In 2019 and early 2020, many value companies faced a growing crisis in confidence. Investors feared that either a recession or technological disruption—or both—would crush value profits. But earnings for value companies have been stronger than expected, and the extensive negative revisions of early 2020 didn’t last. Analysts recognized that their initial dire forecasts were too pessimistic, leading to significant positive revisions through the balance of 2020 and into 2021 (Display).
Rising interest rates should also support small-cap value companies. While the US Federal Reserve’s interest rates remain at historic lows, the yield on the 10-year US Treasury climbed from about 0.9% to 1.7% during the first quarter. Higher rates increase the discount rate used to gauge the present value of future cash flows for investments.
Elevated discount rates cause the market to devalue assets with future cash flows—the further out those cash flows are, the deeper the impact. This scenario makes value companies with current earnings and lower valuations relatively more attractive than hypergrowth companies, with their future expected earnings.
How Sustainable Is This Value Run?
With the pandemic’s effects on the US economy lessening, aided by massive fiscal stimulus, the earnings backdrop is improving for value companies that have already come through the recovery. The risk landscape for stocks is also starting to clear. And as earnings and cash-flow growth become more plentiful, we believe value stocks, with their lower valuations, will remain more appealing to investors.
This value recovery will certainly face unique challenges. Interest rates could reverse, the pandemic could have a resurgence or something currently unforeseen could occur. Despite the risks, we believe economic activity for the balance of 2021 will be stronger than it was during last year’s global shutdown. The US economy is already coming through the recovery phase, which should improve the risk environment for value stocks.
Have We Missed the Sweet Spot?
After such a strong run for smaller value stocks over the last two quarters, it’s natural to think that the rebound might be done. Yet relative valuations suggest there’s still plenty of room for recovery. Value stocks always trade at a discount to growth stocks. The median valuation discount for the Russell 2000 Value to the Russell 1000 Growth has been 29% over the past 22 years, using a valuation composite of one-third price/forward earnings, one-third price/sales and one-third price/cash flow. But during the pandemic, that discount jumped to as high as 65%, a level not seen since the dotcom bubble in 2000 (Display).
Even though value has handily outperformed growth for six months, value’s vast discount to growth has barely budged; the discount has narrowed to 55% from 65%. That’s still a long way from the 29% median. After the tech bubble, value stocks traded at a similar discount. The recovery unfolded in fits and starts and took seven years to fully play out. Over that period, smaller value stocks outperformed large-cap growth companies by a cumulative 205%.
It’s too soon to say how long the current rebound will take or how far it will ultimately go. But at current valuations, we believe small-cap value stocks are still undervalued, and the potential narrowing of the discount can drive a lot of outperformance.
But risks do remain, so we recommend focusing on companies with first-class profitability and avoiding risky companies. We find consumer and industrial companies with strong brands and quality management teams particularly interesting. Companies that can reduce costs, improve operations and increase pricing should be able to magnify the economic recovery. Businesses with these features should benefit from improving cash-flow generation, which can garner higher valuations.
The bottom line: we think there’s more pent-up potential left in small-cap value stocks. For investors who have enjoyed the past six months of outperformance, we recommend reviewing portfolios to ensure that allocations remain appropriate. Investors who may have missed the first leg of the small-cap value rebound should consider initiating or expanding allocations to this asset class.
James MacGregor is Chief Investment Officer—US Small and Mid Cap Value Equities; Head—US Value Equities at AB
Erik Turenchalk is Portfolio Manager—US Small and Mid Cap Value Equities at AB
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams and are subject to revision over time.