Small caps recently broke out of an eight-month sideways consolidation, making a broad and powerful move even as inflationary numbers surge. The Russell 2000 Index has advanced more than 5% so far in November while reaching new all-time highs. The breakout was powered by taper language from the Fed that was more dovish than expected and, we think even most importantly, strong third-quarter earnings. With most companies in the small-cap index, having reported better than expected third quarter earnings, total small-cap earnings are expected to rise over 50% on strong sales growth even with rising labor cost and supply chain issues. Pricing power has been key during the most recent quarter, a trend that we believe will continue well into next year.

Despite lingering global supply chain disruptions and elevated inflation, smaller companies have mostly been successful navigating most of these margin headwinds by relying on pricing power. The Energy, Materials, and Industrials sectors led the way in the quarter, each delivering generally strong earnings growth and margin upside while Utilities and Consumer Staples lagged. In our own portfolios, industrial distributors, select retailers, and machinery companies were among the industries that showed the strongest earnings growth while highlighting their respective abilities to pass on costs. Perhaps the reporting season’s most interesting development was the divergence between beats and misses, as even low valuation, low expectation stocks, which would usually have some shelter if they missed, were dramatically punished.

As we look to 2022, earnings expectations should reflect continued economic growth. Given the strong global growth backdrop and related positive results from companies in the first three quarters of 2021, expectations are moving higher in most sectors even as uncertainty around labor costs, supply chains, and future corporate tax policy lingers. The clear risk as we move forward is how companies weigh robust demand and the inability to fulfill orders—which could lead to eventual demand destruction. At the same time, it is important to highlight that the improvement in corporate earnings outside the U.S. is still unfolding as most other countries have lagged in the recovery and so could represent further upside into 2022.

So while inflation has assumed center stage, it has not derailed the equity markets or blunted earnings growth. More than a year after Pfizer announced its first positive vaccine results in fall 2020, the Russell 2000 has advanced more than 40% through mid-November 2021. Price pressures may continue for the next several months, but supply bottlenecks are showing signs of easing. Against this cautiously optimistic backdrop, earnings have been key to returns, and will continue to be. To be sure, our expectation is that pro-cyclical groups will continue leading the way. Upward earnings revisions reflect confidence in economic expansion even among those sectors hardest hit by the pandemic. And economic expansion has historically left small-cap earnings poised to exceed those of their large-cap siblings, which should in turn drive relative outperformance. Adding to this optimistic view, small-cap’s relative valuation versus large cap remains near 20-year lows even with November’s strong results so far.

A more traditional economic cycle should show growth and profitability coming from a broader swath of the overall economy—as has been the case since roughly last fall. Yet earnings comparisons will also become more difficult next year, which will likely make the market more selective, resulting in lower overall returns. However, history shows that active small-cap strategies have done better in high single-digit return periods. In our view, employing disciplined and differentiated active approaches through this transitional period will be paramount to achieving strong absolute and relative returns going forward.

Stay tuned…

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