Why Get Less When You Can Get More

TUE 08 FEB 2022

Earlier this week we had an interesting question on whether there was “value” in small companies, specifically US small companies. The observation was likely prompted by the large (25%) under performance of the Russell 2000 relative to the S&P500 over the past year. Of course, price is what you pay and value is what you get. From our perch, the Russell 2000 is not particularly interesting on “conditional” based measures of valuation. The forward price-earnings multiple is 22 times and still at a premium to the S&P500. That’s not to say that it cannot outperform if investors become more optimistic again on the cycle. However, the starting odds are not great.

We would also note that balance sheet leverage (Net Debt/EBITDA) is also elevated compared to the S&P500. That is not a particularly attractive combination as macro conditions become more challenging; rates rise, liquidity is withdrawn and growth momentum fades. Indeed, the given the sensitivity of Russell 2000 earnings to the growth and profit cycle, its relative performance to the S&P500 has often provided a lead (or reality check) on the cycle.

Curiously, the underperformance of the Russell relative to the S&P500 since mid-2021 has diverged from the performance of cyclicals/defensives (chart 1). However, it is consistent with flattening of the yield curve, the recent tightening in financial conditions and peak in other lead indicators of the macro cycle such as ISM new orders.

The recent performance of the Russell 2000 relative to the S&P500 also appears inconsistent with the hawkish pivot by central banks, the impulsive rise in sovereign yields, and the recovery in value versus growth equity (chart 2). To be fair, on a longer time frame, an initial lift-off in policy rates is unlikely to end the cycle. As we have noted before, the real damage from higher rates tends to occur later in the cycle when tighter policy flattens/inverts the curve. We are still probably a long way from that point. Put another way it is probably too early to be too pessimistic on growth and profits as the economy reopens.

Taking a step back for a longer term perspective, major tightening cycles by the Federal Reserve have tended to drive long term trends in “value” relative to “growth” equity (chart 3). Of course, “value” has underperformed growth by a considerable margin for more than a decade since the Lehman crisis. In what was perceived to be a period of scarce growth, with low inflation and permanently low rates, investors overpaid for companies that could deliver profits. From our perch it is not certain that the global economy has escaped secular stagnation, but if the regime has shifted, the potential rate, liquidity and vol shock could be profound.

The key implication for portfolio construction is that; 1) you ought to prefer entities that have strong cash flow, and low balance sheet leverage; and 2) fixed income is unlikely to be a diversifier for equity. We would also note that the regime could shift again if convexity of the rate/vol shock caused a large “value-at-risk” shock for credit and equities.