U.S. Equities

The opportunity in small and microcap equity

Small and microcap valuations appear close to approaching previous recessionary lows, and previous market rebounds have been led by small and microcap.
April 2020

The ten year bull market in US equities ended abruptly in February 2020 as investors started to appreciate the health care, economic, and financial implications of COVID-19. In one of the sharpest selloffs on record, US large cap (measured by the Russell 1000 Index) experienced a peak-to-trough decline of approximately 35%, while US small cap (measured by the Russell 2000 Index) experienced a greater decline of over 40%. As of this writing, investors are grappling with questions including:

  • Health care: when and how will the COVID-19 ultimately be contained?
  • Economic: how long and deep will the recession be, and how quickly will the economy rebound?
  • Financial markets: how low will US equity markets fall and when will we find a sustainable bottom?

 

With that said, long-term investors are starting to ask another question: Given the magnitude of the decline so far, and the historical pattern that markets typically bottom before the economy recovers, when and how should investors be positioning for the eventual rebound?

While no one can answer the timing question right now, in this article we present evidence for long-term investors that suggests:

  • Small and microcap stocks have typically outperformed in significant market rebounds
  • Small and microcap valuations are close to the troughs realized in the Great Financial Crisis of 2008-09

In our view, this creates a compelling opportunity for long-term investors who are willing to endure near-term volatility for higher long-term expected returns.

Small and microcap stocks have typically led in market rebounds

Following prior drawdowns, small cap and microcap have been very attractive during the subsequent economic rebound.  While this has been generally true in market recoveries, given the extent of the 2020 drawdown, we focused our analysis on the most significant corrections in the past twenty years:  2001-20021 (Internet bubble), 2008-2009 (Financial Crisis), and 2015-2016.

The key observation: In each of these recoveries, we note that microcap has led small cap, which has in turn led large cap. Moreover, the cumulative returns are similar, reinforcing that given the relative underperformance of small cap to date, we would expect it to outperform from here through the recovery. 

Index Period leading to trough: 07/01/2001 through 10/11/2002 Period recovering from trough: 10/11/2002 through 05/30/2003

Russell 1000® Index

-24.6%

22.1%

Russell 2000® Index

-25.6%

32.4%

Russell Microcap® Index

-23.5%

39.2%

Index Period leading to trough - 11/30/2007 through 03/09/2009 Period recovering from trough: 03/09/2009 through 12/31/2009

Russell 1000® Index

-44.4%

67.8%

Russell 2000® Index

-45.9%

80.4%

Russell Microcap® Index

-50.2%

81.0%

Index Period leading to trough: 06/26/2015 through 02/09/2016 Period recovering from trough: 02/09/2016 through 12/30/2016

Russell 1000® Index

-12.2%

24.2%

Russell 2000® Index

-24.2%

42.0%

Russell Microcap® Index

-27.2%

43.4%

Index Period leading to trough: 02/15/2020 through 03/27/2020 Period recovering from trough: 03/27/2020 through ???

Russell 1000® Index

-25.3%

TBD

Russell 2000® Index

-32.8%

TBD

Russell Microcap® Index

-33.3%

TBD

Small and microcap valuations are historically attractive

Current valuations within small cap and microcap are quite depressed, close to levels reached at the depth of the financial crisis.  One caveat would be that forward estimates have mostly not been revised downward yet, whereas in 2009 economic conditions had already deteriorated for a few quarters, allowing analysts to make a better estimate of the negative impact on earnings.  However, it’s also not clear how long depressed earnings will last as that depends on the path of virus containment.  Given uncertainty and lack of company guidance around earnings and duration, we think it’s most appropriate to use normalized metrics (Price/Book, Price/Sales) as well as further-out estimates (FY2 rather than FY1).  These metrics suggest small cap valuations are between those reached at the previous two troughs, and that microcap valuations are close to those observed at the bottom of the financial crisis.

Calculation 03/09/2009 02/09/2016 03/31/2020

Price/Earnings

9.6

16.8

13.1

P/E using FY1 Est

9.6

14.8

13.3

Price/Cash Flow

3.9

8.1

6.3

P/E using FY2 Est

8.5

13.9

11.7

Price/Book

0.9

1.7

1.4

Price/Sales

0.6

0.9

0.8

Calculation 03/09/2009 02/09/2016 03/31/2020

Price/Earnings

9.8

14.8

10.2

P/E using FY1 Est

9.4

13.9

10.4

Price/Cash Flow

3.1

7.3

4.5

P/E using FY2 Est

8.4

12.5

9.2

Price/Book

0.7

1.3

1.2

Price/Sales

0.5

0.7

0.5

Conclusion

We cannot predict the timing of how long this recession will last or when the market will bottom.  To be clear, we must consider the possibility that markets have not yet bottomed.  In previous cases, the market decline has lasted longer than the 1.5 months we’ve experienced thus far.

However, for a long-term investor looking out 12-18 months, we feel the above analysis represents the opportunity well.  Small and microcap valuations appear close to approaching previous recessionary lows, and previous market rebounds have been led by small and microcap.  Given the extent of the decline already experienced, with small significantly lagging large on the way down, we believe long-term investors are facing an above-average opportunity in US small and microcap equities.

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Disclosures

1 We start the Internet Bubble analysis in 7/2001 due to inception of Microcap Index.

The Russell Microcap® Index includes the smallest 1,000 securities in the small-cap Russell 2000® Index, plus the next smaller 1,000 securities.

Russell 2000® Index is an unmanaged index that measures the performance of the smallest 2000 U.S. companies in the Russell 3000® Index.

The Russell 1000® Index is a stock market index that represents the highest-ranking 1,000 stocks in the Russell 3000® Index.

Investments cannot be made in an index.

Views and opinions have been arrived at by BMO Global Asset Management. The information, estimates or forecasts provided were obtained from sources reasonably deemed to be reliable but are subject to change at any time.

This publication is prepared for general information only; it should not be construed as investment advice or relied upon in making an investment decision. Investment in the asset classes discussed is not suitable for every individual. All investments involve risk, including the loss of principal. Past performance is not a guarantee of future results.

Small-Cap and Micro-Cap stocks are less liquid and are more volatile than large-cap stocks.

The Price to Earnings Ratio (also called the PE ratio) is the primary valuation ratio used by most equity investors. It is a measure of the price paid for a share relative to the annual net income or profit earned by the firm per share. Forward price-to-earnings (P/E using FY1 & P/E using FY2) is a version of the ratio of price-to-earnings (P/E) that uses forecasted earnings for the P/E calculation. Future performance cannot be guaranteed.

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