Celebrating 25 Years of Small Caps
The Jennison Small Cap Core Strategy 25th Anniversary page highlights this milestone with exclusive content that looks back on the team’s long tenure.
After lagging their growth counterparts for eight of the previous ten years, small-cap value stocks began to outperform in 2021, a trend that has carried over into 20221 (Exhibit 1). The recent change in style leadership reinforces the risks of a growth/value barbell approach. Focusing too much on growth or value has historically led to more concentrated risk and the potential for more extreme volatility.
Exhibit 1 reinforces this risk, as growth and value styles have experienced significant dispersion in returns over the past 20 years. The illiquid nature of many of the stocks that comprise small cap indices often results in wide performance spreads among both individual stocks and broad styles. This is evident when comparing calendar year returns for the Russell 2000 Growth index and the Russell 2000 Value index. Since 2002, there have been 10 calendar years where the difference in returns has exceeded 10%, with three observations in recent years where the spread exceeded 20%. In addition, as Exhibit 1 also highlights, there have been periods of two consecutive years where the sum of the difference in returns between the two indices has exceeded 30% and 50%, respectively.
From a sector perspective as of April 30, 2022, the Russell 2000 Value index has a high concentration in industrials and financials, while the Russell 2000 Growth index has a large concentration in healthcare and information technology (Exhibit 2). A common misconception is that investment allocations must be either growth or value. It’s important to realize that these styles are often defined by their concentrated industry exposures. The wide dispersion in performance between small-cap value and growth is also a result of these stark differences between the value and growth indices.
From our bottom-up perspective, there tends to be a high percentage of low earnings growth, low margin and highly cyclical business models in small-cap value, leading to a lower quality tilt. On the other hand, small-cap growth tends to have significant exposure to high-momentum stocks. As we have seen over the past 20 years, when either style is out of favor, the drawdown and performance spread between the two can be significant.
We believe applying a core approach to small cap investing might help offset the concentration risks of a dedicated small-cap value and/or growth allocation, and alleviate the burden of timing a rebalance between the two.
An active small-cap core strategy can manage portfolio exposure risk and provide greater flexibility to move across industries and sectors, thus offering broader diversification within small cap.
Additionally, Exhibit 3 shows that small-cap core portfolios offer exposure to business models that may either benefit from an economic expansion, low growth or scarcity of growth environment, or uncertain economic backdrop. Conversely, the chart also highlights that the pure style indices are overexposed to either cyclicals (value index) or underexposed to more stable, defensive names (growth index). As seen in the Russell 2000 index’s weighting, a core approach offers more balanced exposure across cyclical/rate sensitive, defensive, and secular growth sectors.
As Exhibit 4 highlights, this is the twelfth year of a large cap outperformance cycle, which has led to small caps trailing large caps by an average of 380 basis points on an annualized basis.
On average, small-cap stocks have made up about 7.5% 2 of the overall US equity market. Today, small-cap stocks make up less than 5% of that market,3 thanks in part to the massive and prolonged run of a handful of stocks that have become mega caps. Across market cycles, we believe small caps can help diversify a broader equity allocation as investors prepare for changing environments and scenarios.
With room for small cap stocks to revert to their long-term average in terms of percentage of the overall US equity market, their diversification potential can be particularly compelling at this stage of the current market cycle. Of course, as recent market turbulence has highlighted, small caps have historically suffered periods of significant volatility, and gaining small cap exposure through a pure value or pure growth approach has historically amplified these gyrations.
We believe a diversified small cap core allocation, focusing on quality business models in attractive industries, with balance sheet flexibility, strong earnings and cash flow growth prospects, led by capable management teams can have meaningful benefits over more concentrated style approaches.
1Throughout this piece, references to “small-cap value” or “value” and “small cap growth” or “growth” are referring to the Russell 2000 Value Index and the Russell 2000 Growth Index, respectively.
2, 3As of 04.22.22. Source: Jefferies Equity Research SMID-Cap Themes—Focusing on the balance sheet; 20 GARP names to chew on
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The Russell 2000 Index is a small-cap stock market index that makes up the smallest 2,000 stocks in the Russell 3000 Index. It was started by the Frank Russell Company in 1984. The index is maintained by FTSE Russell, a subsidiary of the London Stock Exchange Group (LSEG). The Russell 2000® Growth Index measures the performance of those Russell 2000® companies with higher price-to-book ratios and higher forecasted growth values. The Russell 2000® Value Index measures the performance of those Russell 2000® companies with lower price-to-book ratios and lower forecasted growth values.
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CRSP Cap-Based Portfolio Index data are a monthly series based on portfolios that are rebalanced quarterly. The universe includes all common stocks listed on the NYSE, NYSE MKT, and NASDAQ National Market excluding Unit Investment Trusts, Closed-End Funds, REITs, Americus Trusts, foreign stocks and American Depositary Receipts. Eligible companies with primary listings on the NYSE are ranked into equally populated deciles. The largest capitalizations in each decile serve as the breakpoints that are applied to various exchange groupings of the universe. Individual decile portfolios are created for each exchange group, the largest being in decile 1 and the smallest in decile 10. In addition to each decile portfolio, returns are calculated for the following: CRSP 1-2, CRSP 3-5, CRSP 6- 8, CRSP 9-10, CRSP 6-10 and CRSP 1-10.