It has been a hot summer, and there has been little rest for weary investors. The equity markets are seemingly caught in a daily tug-of-war between inflation, recession, mixed macroeconomic data points, and stronger microeconomic comments from corporations across many different industries as they report second quarter earnings. Layer on top of that geopolitical uncertainties, deglobalization, anxieties about new fiscal stimulus, and the upcoming midterm elections, and you have a volatile mix. To be sure, the resiliency that the equity markets have demonstrated of late is impressive, especially in the face of this intense macro uncertainty. After falling 32% from their November 2021 peak through the lows of mid-June, part of the worst first half in its history, the Russell 2000 Index has rallied more than 22% off the low and so far gained more than 18% in the third quarter alone. So how should one position themselves in this uncertain environment? Should you rent this powerful rally or own it?

From our perspective, the rally from the depths of June has been driven largely by short covering and lower quality names, which have been pushing multiples of the indexes higher. Interestingly, on a market-cap weighted basis, negative earning companies represented 27% of the Russell 2000 on 6/16/22 and have returned 30.4% from that trough through 8/15/22. Quarter to date, companies with negative earnings before interest and taxes (EBIT) have returned 27.0%. At the same time, many of the performance trends that were in place in the volatile second quarter have reversed in the recent market rally. Value is underperforming growth quarter-to-date, and quality (which we measure primarily by high returns on invested capital) is modestly trailing those lower quality businesses, as seen in the two charts below, the second of which looks at the top and bottom fifth of the Russell 2000 sorted by returns on invested capital.

Small-Cap’s Short-Term Reversals
2Q22 and 3Q22 (through 7/31/22) Performance for the Russell 2000 Value and Growth Indexes and the Russell 2000 Index’s Highest and Lowest Return on Invested Capital Quintiles

Past performance is no guarantee of future results. Return on Invested Capital (ROIC) is calculated by dividing a company’s past 12 months of operating income (earnings before interest and taxes) by its average invested capital (total equity, less cash and cash equivalents, plus total debt, minority interest, and preferred stock).

In this context, we think it is important to note that, even with the market’s recent upward move, as of 8/15/22 the Russell 2000 Value and Core Indexes remain the cheapest segments of the U.S. market—and the only ones that are at or below their 25-year average valuation, as shown in the chart below.

Current and 25-Year Average Median EV/EBIT¹ (ex Negative EBIT) Levels for Russell Indexes
As of 8/12/22

¹Enterprise Value/Earnings Before Interest and Taxes

For some time, we have suggested that value and higher-quality companies would lead in the market recovery. Though these stocks are lagging so far in this rebound, they look attractively undervalued to us, are defensive by nature, and tend to perform better in periods of heightened volatility. Second-quarter results confirmed that these businesses are navigating this environment well on a relative basis, though the market has yet to recognize the value that is being created. Current economic conditions are quite dynamic and so much more fluid than the daily headlines suggest. Given the low quality nature of this rally, then, we would not be surprised if the next market move was corrective, as few of the stocks that have benefited most were selling at historically attractive valuations. Moreover, the U.S. economy looks to be in better shape than many observers are saying.

Volatility appears likely to increase over the next several months as the market enters the historically difficult months of September and October and the economy continues to slow. Investors will continue to grapple with the consequences of an improving inflation outlook, a potential pivot in monetary policy, and the risk of earnings contraction as tighter financial conditions cool demand. Amid this ongoing uncertainty, we remain steadfast in our approaches that focus on quality and value.

While there is no easy answer to the question of what happens next, we have always believed in the critical importance of focusing on what we know and not worrying about what we cannot control. Our belief is that subsequent performance should better reflect underlying fundamentals and therefore stock picking should once again be rewarded. The small-cap asset class, even more so than others, is generally misunderstood and much larger than any one index. While blanket statements about overall valuations are tempting to make, we think that today’s environment argues for a more active and disciplined approach—one where opportunities are identified by sound fundamentals selling at attractive absolute valuations. So while the debate over whether to rent or own this rally will rage on, we think it’s best to own small-cap value and quality for the long term.

Stay tuned...

Important Disclosure Information