Small Caps: Finding Opportunities in Divergence

By Matthew Oldroyd, CFA, CAIA - August 22, 2017

The relative performance of small-cap growth and value stocks has been cyclical over time, but small-cap growth companies have more recently grabbed the headlines—and the returns. Year to date as of July 31, the Russell 2000® Growth Index has outperformed the Russell 2000® Value Index by more than 10%, leading to a wide difference in valuation for the two styles. We believe both have important roles to play in a diversified portfolio, but investors may wonder about the performance of their value holdings.

This leaves small-cap stocks at an interesting point: Even though price-to-earnings (P/E ratios) for both indices are higher than their 10-year averages, the difference between the two has been widening in 2017. As we can see in the chart, the small-cap growth index’s P/E ratio has risen sharply this year. (Higher P/Es imply that a stock’s earnings are valued more highly, usually on the basis of higher expected earnings growth or quality of earnings.)

Data from 1/1/2007 to 7/31/2017.
Source: FactSet.

What’s driving this change? On the growth side, recent surging performance by biotech companies has been a major factor in the index’s strong results. The small-cap value index, on the other hand, has been challenged so far this year due to heavy exposure to banks and oil exploration and production companies. Banks have retrenched after a significant run-up following the U.S. presidential election, and oil stocks have been hit hard by the inability of energy prices to rebound in a sustainable way.

As a result, investor sentiment has been on the side of small-cap growth, driving P/Es higher and widening the difference between growth and value. This divergence indicates that small-cap value may be cheaper relative to small-cap growth, providing the potential to find attractively valued stocks.

Additionally, we believe small-cap value may have more potential than other segments of the market to receive a boost from any surprise rebirth of President Trump’s agenda and policy implementation. Small-cap value stocks may have greater exposure to opportunities driven by a rising interest rate environment, corporate tax cuts, lower regulation, and infrastructure spending.

Matthew Oldroyd, CFA, CAIA
Matthew Oldroyd, CFA, CAIA

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      The opinions expressed are those of American Century Investments (or the portfolio manager) and are no guarantee of the future performance of any American Century Investments' portfolio. This material has been prepared for educational purposes only. It is not intended to provide, and should not be relied upon for, investment, accounting, legal or tax advice.