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4 reasons why recent market turbulence may signal the long awaited rotation into small cap value

4 reasons why recent market turbulence may signal the long awaited rotation into small cap value

Market commentary
16 October 2018

Four reasons why small cap value looks set to recover

Fuelled by exceptionally loose monetary policy, value stocks have struggled relative to growth since the end of the global financial crisis in 2009. Over the last 18 months this trend has intensified, especially among developed-market small-cap stocks, with the most speculative of growth names - those with most optimistic growth expectations - leading the market. (Exhibit 1) 

 

Exhibit 1: Value has been weak over the last 18-months

Source: Rosenberg Equities, Thomson Reuters DataStream, IBES, MSCI.  Exhibit 1 - ‘Rosenberg Valuation Model’ refers to Rosenberg Equity’s proprietary measure of fair value which is based on a detailed assessment of individual securities’ industry, balance sheet and income statements. ‘Long Run’ defined as Dec 2003-Jul 2018.  Past performance is not a guide to future performance. 

 

We believe that the market is now poised to shift back in favour of increasingly undervalued small-cap value stocks and away from increasingly speculative growth ones.

  • Small-cap value should benefit from rising interest rates
  • History suggests speculative growth stocks ultimately let you down
  • Small-cap value is very oversold
  • Small-cap value is now cheap

 

1. History suggests speculative growth ultimately lets you down

Small-cap equity performance has become increasingly driven by ‘speculative growth’ stocks. Our research shows that over the last year, companies with the highest earnings and revenue expectations have outperformed the market by over 3%. However, history suggests that these ‘speculative growth’ stocks ultimately disappoint because they fail to deliver relative to their lofty expectations; as such, they have been poor long-run investments.

Exhibit 2 shows that while the global small cap companies with the highest forecasted sales and earnings growth (top quintile) did indeed deliver the highest realised sales and earnings growth over the subsequent three years, the gap between forecast and delivery was substantially bigger for this group than the others. This disappointment caused the highest forecasted group to underperform their industry peers by over 4% on average over the following 12 months, as investors punished these stocks for over-promising and under-delivering.

We view the recent strong performance of ‘speculative growth’ stocks with scepticism and believe that, in the long-run, disappointment will again lead to underperformance.  

Exhibit 2 – Highest forecasted growth has disappointed in the long run

Exhibit 2 Source: Rosenberg Equities, IBES. Dataset covers 2000 to 2017 for companies in Rosenberg Equities’ global small cap universe with available consensus forecasts. For each item shown, the median is shown for each of five ‘buckets’ of forecast sales growth. The lowest growth forecast bucket is labelled ‘1’, the highest is labelled ‘5’. ‘Rel. return’ is one year ahead total return relative to regional average  Past performance is not a guide to future performance. 

 

2. Small-cap value is very oversold

The duration and magnitude of value’s underperformance relative to growth has reached levels not seen since the technology bubble of the late 1990s. Exhibit 3 shows the cumulative percentage difference between the relative performance of small-cap value and growth stocks compared with the long-term trend. The latest observation shows that US small-cap value stocks are underperforming growth by 26% compared with the historical trend. This underperformance is just over one standard deviation (the dashed lines in the chart) below the long-term average.

As shown in the periods circled in red, reversals from similar levels of value underperformance in the past have typically been sharp.

Exhibit 3 – Value relative to growth: % deviation from trend, US and Global

Exhibit 3 Source:  Rosenberg Equities, Thomson Reuters DataStream, FTSE Russell, MSCI.  Data for US is Russell 2000 Value index vs. Russell 2000 Growth index, while data for Global is MSCI World Small Cap Value index vs. MSCI World Small Cap Growth index.  Data in USD terms to 31 August 2018.  Growth and Value are defined by the index provider.  Past performance is not a guide to future performance

 

3. Small-cap value is now cheap

The underperformance of small cap value stocks has created historically large valuation opportunities.  Small-cap growth stocks are currently trading at just over four times the price-to-book multiple and three times the price-to-forecasted earnings multiple of value stocks globally - levels not seen since the technology stock bubble of the late 1990s. (Exhibits 4 and 5)

Exhibit 4 – Book-to-Price valuation premium for growth

Source: Rosenberg Equities, IBES.  Data is for Rosenberg Equities' Global Small Cap universe (Exhibit 4) to end July 2018. 

 

Exhibit 5 – Forecast Earning-to-Price premium for growth

Source: Rosenberg Equities, IBES.  Data is for Rosenberg Equities' US Small Cap universe (Exhibit 5) to end July 2018.

 

Stretched valuations for growth stocks persist because of the high expectations built into share prices, but as we explained in reason 1, above, the future fundamentals delivered by expensive growth stocks have often disappointed. When that happens, investors should reconcile stock prices with company fundamentals, forcing the valuation premium to return to more normal levels.

 

4. Small-cap value should be a beneficiary of rising interest rates

The post-global financial crisis bull market for growth stocks has been accompanied by an abnormally low interest-rate environment. As rates have fallen, investors have been less concerned about capturing earnings today and appear willing to pay an increasingly high premium for the promise of growth in the future; a promise that often ends disappointingly for investors in those high-growth stocks.

We believe that normalising monetary policy will ultimately drive a re-rating of value relative to growth. While its noteworthy that growth styles suffered as bond yield rose during the early October market turbulence,  we are yet to see a meaningful recovery in value given the rising rate environment . Our view is that this decoupling is unlikely to persist.

 

In our view the weak performance of small cap value relative to growth has been driven by the exceptionally loose monetary policy of the past decade and more recently increasing unrealistic earnings expectations for fast-growing companies. We believe that an environment of rising interest rates, attractive valuations, and the always-present tendency for the highest-growth stocks to deliver disappointing fundamentals, potentially sets the stage for small-cap value to outperform once again.

Notes to editors

Media contacts

Jayne Adair

+44 20 7003 2232

Jayne.Adair@axa-im.com

 

Jamie Wynn-Williams

+44 20 7003 2680

Jamie.Wynn-Williams@axa-im.com

 

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Authors
Jonathan White, Head of Client Portfolio Management, Rosenberg Equities