After a near-record sell-off in February, US small-cap equities now have the potential to outperform as the US economy begins to stabilise. Small-cap stocks have historically been the best way to get exposure to US recoveries: on average, from the bottom of bear markets since 1949, the Russell 2000 has generated annualized total returns of 58% in the first year following the market bottom, 26% over three years and 21% over five years, while outperforming the S&P 500 by 16%, 5%, and 4%, respectively.
Many smaller companies are at the epicenter of secular growth themes fueled by technological innovation, and these themes have actually accelerated during the Covid-19 pandemic. As Americans stay at home, life has moved online: we are working, schooling and even seeing a doctor from home. Experiences are being digitalised, and often personalised and made more convenient, leading to better outcomes and potentially permanent behavioral habits.
Companies that provide these digital experiences, as well as technology companies that enable and facilitate the transitions to digital experiences, are poised to thrive. We like select companies tied to digital transformation or using technology to improve business processes and productivity—whether it’s a company that allows us all to stream what we want to watch, securely in the cloud, or one that provides next-generation identity access management.
Another secular growth theme we like is genomics. In addition to potentially providing solutions for thousands of genetic disorders in the future, genomics is playing a huge role in helping researchers better understand Covid-19 and accelerating the ability to develop a vaccine. Many of these companies can only be found in small caps.
Concerns over leverage and heightened recession vulnerability have weighed on investor sentiment for small caps, though these have been lessened as the market has started to look through to a recovery. In our view, these concerns can be mitigated through a high-quality approach driven by stock selection. We focus on companies with strong balance sheets that possess little insolvency risk given their above-average growth, cash-rich operations and durable competitive advantages. Some small-cap companies are actually far less levered than most of the companies in the S&P 500 and have declined less during the drawdowns this year.
For investors with a long-term investment horizon, we believe that US small caps are an important investment allocation for long-term wealth creation, and they are often under-represented in portfolios.
Greg Tuorto is a portfolio manager in the fundamental equity US small-cap team at Goldman Sachs Asset Management
Bull points
• Historically, following the bottom of recessionary bear markets, forward returns of small-cap stocks have been robust and outpaced large caps.
• Long-term value creation is based on higher earnings growth compounding potential.
Bear points
• Increased volatility or a market downturn could impact small caps more than large caps.
• More loss-making or unprofitable companies exist at smaller market caps, which could disproportionately suffer against a backdrop of economic weakness.
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