Small-cap value funds have enjoyed a moment in the sun in the wake of the US election, but investors in these strategies have seen more than a decade of frustrating returns.
Amid years of performance headwinds, managers on such funds have adopted somewhat different approaches to improving returns, such as emphasizing quality in their stock screens to avoid buying cheap stocks that get cheaper. Still, it has been a tough slog.
Take the returns seen so far this year. Small-cap value funds are up an average of 12.4% in 2024, trailing far behind the 28.5% gain on large growth funds—the best-performing category among the nine diversified US stock fund categories. Out of the nearly 170 US small-cap value funds tracked by Morningstar, only eight are ahead of the 26.6% return on the US Market Index. Those returns come despite a jump in small-cap value since the election; these funds are up an average of 7.4% since Nov. 5, while the broader market is up 3.9%.
“The facts speak for themselves: It’s absolutely not the year for small-cap value investing,” says Ryan Kelley, chief investment officer at Hennessy Funds. He’s one of the managers of the $1.7 billion Hennessy Cornerstone Mid Cap 30 HFMDX, the best-performing small-cap value fund based on its 38.1% year-to-date return.
Despite the category’s long-term woes, some veteran fund managers believe there’s potential for a revival.
“The underperformance hasn’t been because small value companies have been terrible,” says Rob Arnott, founder and chairman of Research Affiliates and co-manager of the $1.6 billion PIMCO RAE US Small Fund PMJIX.
“It’s been because small value stocks have been falling further out of favor and getting cheaper relative to their underlying fundamentals.” Arnott says US small-cap value stocks trade at a bit more than a 90% discount to small-cap growth stocks, compared with their 81% median value since 1968.
Why Have Small Caps and Value Suffered?
Managers can offer a long list of reasons small-cap value funds have underperformed. For much of the last 15 years, one challenge has been low interest rates, which tend to benefit growth stocks more than value ones because they make the earnings of growth companies more attractive. Notably, even when the Federal Reserve raised interest rates, that didn’t benefit small-value stocks.
Some fund managers blame the rise of indexing, which has funneled huge sums into the largest stocks. They argue that with more money going to index funds, fewer investors are looking to buy undervalued stocks or avoiding overvalued ones, leading to less pressure for stocks to align with the underlying value of their businesses. “Maybe this is what we get with all of the flows being either passive or index,” says Joshua Wein, another manager on the Hennessy Mid Cap fund. He adds that more value investors looking at stock fundamentals “probably affected the stock price a lot more than it does now.”
Additionally, global trade substantially expanded in the time between the end of the global financial crisis and the outbreak of the covid-19 pandemic. Small US companies tend to rely less on international markets than larger ones, so expanding trade disproportionately benefits large firms. “[For] US companies, profitability [became] much greater because of outsourcing,” says Wein.
Adjusting Strategies
The long spell of underperformance for small-cap value led some managers to adjust their strategies.
The $52 million James Small Cap Fund JASCX has risen from the 97th percentile in the category based on 2018 returns to the 4th based on year-to-date returns in 2024. “From 2015 to about 2019, the performance [of the fund] had really lagged, even [relative] to value,” says Brian Culpepper, one of the fund’s portfolio managers. “I think that was a reliance too much on our model, and that put us too much in deep value [companies].” Such firms trade at significant discounts, often with troubled business models.
While their model has always included quantitative metrics besides value-based ones, such as the price/earnings ratio, the fund’s newer emphasis on qualitative analysis has led them to reemphasize other investing factors.
One big pitfall in value investing comes from stocks known as value traps. Such stocks appear inexpensive, but due to issues with their underlying business, they fall further instead of rebounding. Part of the challenge is that inexpensiveness isn’t always a measure of value. Arnott acknowledges this: “Value traps look cheap all the way to zero.”
One way managers try to screen for this is by looking at a stock’s momentum, which is how much it’s risen over a period (often the past six or 12 months). They have also tried focusing on quality—metrics showing the strength and durability of an underlying business, such as profit margins, debt levels, and stable earnings over time. Arnott argues that by using quality and momentum metrics, investors can avoid value traps, and he says he can be confident that the low valuations of small-cap value stocks represent opportunities.
As value has gotten cheaper, the PIMCO RAE fund has become more value-focused even as value has underperformed. In 2005, when the fund started and value stocks’ discount was in line with the historical average, the fund was only slightly tilted toward value stocks over growth. But as value stocks have become cheaper, the fund has increasingly tilted toward value. “At extremes in the market, things always look like they’re never going to turn,” says Arnott.
The Small-Cap Value Bull Case: A Bearish World
There are many potential catalysts for the return of small-cap value stocks, but most would be bad news for the wider market.
First is deglobalization, which would likely affect small-cap firms less than large-cap ones, which rely more on international trade. “We’re nowhere near where we were pre-pandemic in terms of the free flow of world trade,” says Arnott.
Inflation—a possible outcome of deglobalization due to rising manufacturing costs—is also a potential boon for small-cap stocks. “When you get above 3% inflation during any given 10-year span, we find that value beats growth by 2%-10% per year compounded,” says Arnott.
Arnott likens today’s market conditions to those right before the dot-com bubble popped, and he points out that was the last time value stocks had this large a discount to growth: “Small-cap value was up the first two years of the [dot-com] bear market. If you look at March of 2000 to March of 2002, small-cap value was up 25%-30% and the S&P [500] was down 25%.” He points to value doing much better than growth in market downturns as a way value may begin to outperform. Most recently, the US Market Index fell by 19.4% in 2022, while the US Small Value Index fell by 6.6%.
Election Results: A Catalyst for Small Value?
One recent event that’s helped small-cap value stocks is the election of Donald Trump to a second term as US president. The US Market Index is up 3.5% since the election, while the US Small Value Index is up 5.5%.
“Almost all major stock indexes surged the day after the election results were announced, with small caps performing over two times greater than large. Financials were by far the biggest winners, with Industrials and Energy doing extremely well,” says Kelley.
“It’s clear why small caps moved more. Large caps are dominated by tech … while the largest sector weightings for small caps in the Russell 2000 Index are industrials (19% of the index) and financials (18% of the index).”
Trent Dysert, another portfolio manager on the James fund, says: “The recent surge in small caps post-election looks like the 2016 trend, as investors position themselves in anticipation of policy shifts under a new administration. The potential for reduced regulatory burdens, extended tax cuts, and trade policies favoring domestic manufacturers are key reasons behind the recent rise in small caps.”
The author or authors do not own shares in any securities mentioned in this article. Find out about Morningstar's editorial policies.
