Are US small caps presenting a unique opportunity for active managers?

Small-caps remain mired in a classic bear market, down close to -27.8% from their peak on 11/8/21 through 11/10/23. It has been just over two years, and more than 500 trading days, since the Russell 2000 Index last closed at a 52-week high, the third longest streak in the index’s more than 40-year history. The last few months have not helped, as the Russell 2000 declined for three straight months through the end of October, losing -16.7%.

For some time, we have posited the idea that regime change is on the horizon, especially for small-caps, which have trailed their large-cap siblings for more than a decade. Needless to say, we continue to wait. In the meantime, many small-cap companies are forgotten—and cheap. Yet even as we may possibly be heading towards a long-anticipated recession, our conviction has not wavered. At the risk of overstaing the obvious, we continue to believe that small-caps are well positioned to outperform the market at large. At the same time, we have spoken about the active opportunity in the small-cap market as rates have normalized and the era of “everyone gets a trophy” in terms of the cost of capital has come to an end. Combine both the unique set of market circumstances and the prospects for active management in small-caps today, and we see the opportunity for both alpha and beta in the small-cap asset class.

We appear to have arrived at a unique moment in the small-cap asset class. We have previously noted the dramatic underperformance of the Russell 2000 on a 5-year basis relative to the large-cap Russell 1000 Index. This same period has also unsurprisingly seen low returns for small-cap on an absolute basis—the Russell 2000 gained a paltry 2.4% through the end of September on a 5-year annualized basis. And small-caps continue to trade at their lowest relative valuation versus large-caps in more than 25 years and that small-cap’s weighting in the Russell 3000 is also near a 20-year low.

Many companies we have looked at would appear to have already priced in a recession, in terms of both price-to-earnings and EV/EBIT (enterprise value over earnings before interest and taxes). To be sure, as returns have stalled, multiples have compressed, and many small-caps look undervalued. These attractive valuations for the small-cap index as a whole, and the fact that small-caps have historically enjoyed strong and lasting recoveries following prior periods with low 5-year annualized returns, create what we believe is a potentially rewarding combination for patient and disciplined active small-cap managers versus the broader market.

As confident as we are in small-cap’s long-term prospects, we feel even stronger about the continued opportunity for active management within the asset class. Gone are the days of zero interest rates and easy access to capital. Fundamentals matter once again. To that end, the strength and success of active small-cap management has really stood out over the last several years. As we usually do, we use Morningstar’s Small Blend Category as our proxy for active management. This category beat the Russell 2000 for the 1-, 3-, 5-, and 10-year periods ended 9/30/23. When we excluded index funds and included only the oldest share class of a fund within the category for the periods ended 9/30/23, 146 out of 174 funds outperformed the Russell 2000 for the 1-year period; 150 out of 167 funds beat it for the 3-year period; 131 out of 158 did so for the five-year period; and 88 out of 131 funds beat it for the 10-year period. Equally, if not more important, performance has been strong across our domestic Strategies on both an absolute and relative basis. As bottom-up small-cap stock pickers, however, the most significant factor for us is that most of the management teams we’ve been speaking to remain cautiously optimistic over the long run.

While there is no easy answer to the question of what happens next, we have always believed in the critical importance of focusing on what we know and not worrying about what we cannot control. Today, expectations for small-caps are low and valuations are attractive. In our view, we have this moment from an active standpoint within small-caps to generate alpha going forward, but we also have the market opportunity, given the attractively inexpensive valuations within the small-cap space, from a beta perspective as well.

Stay tuned…