Tajinder Dhillon
July 19, 2021

Rise of the Small-Caps: 21H1 Check-In

by Tajinder Dhillon.

We take a closer look at a less-covered area – small-cap stocks.  Looking at the data in more detail, an argument can be made that the small-cap arena (particularly in the U.S.) is providing a compelling investment case.  Recent price momentum, analyst revisions, and earnings growth indicates a positive outlook for small-cap stocks.

Small-cap stocks have seen a synchronized rise since November 2020 when news of a potential vaccine made headlines.  Smaller companies tend to be domestically oriented with high degrees of leverage and exposure to the local economy.  With a continual gradual re-opening, small-cap stocks have been outperforming large-cap stocks in most regions over the last year.

Using FTSE Russell indices, we can look at small-cap performance vs. large-cap in various regions.  Small-caps have been outperforming in Global, U.S., and European regions as shown in Exhibit 1.

Notably, small-cap performance in these regions accelerated sharply during Q4 2020 and in the U.S., the small-cap outperformance lasted until March 2021 and has since reversed.  However, Asia-Pacific has seen the strongest performance in Q2 2021, with small-cap up 6.1% in comparison to 2.8% for large-cap.

Exhibit 1: Small-cap vs. Large-cap Performance

Moving to the U.S., stock price performance appears to be more broadly based and exhibiting greater breadth.  Exhibit 2 highlights annual total returns of the Russell 2000 vs. Russell 2000 Equal-weighted index.  Year-to-date, the equal-weighted index has gained 21.2% in comparison to 13.9% for the market-cap weighted index.

Index concentration is not a concern in the Russell 2000, as the top 20 constituents only make up 5.1% of the index according to Refinitiv Datastream.  This compares to a 33.2% weight for the top 20 constituents in the Russell 1000 index.  Thus, the equal-weighted performance in the Russell 2000 is of noteworthiness.

We note a similar observation in the Russell 1000 index, as the equal-weighted index has increased 17.3% in comparison to 16.5% for the cap-weighted index.  Perhaps more interesting is that the equal-weighted index is outperforming the cap-weighted index for the first time since 2016.

Exhibit 2: Russell 2000 Cap-weighted vs. Equal-weighted Annual Returns

The rise in share prices are backed by market expectations as the economy re-opens.  Looking at analyst revisions in the U.S., the Russell 2000 Index has seen larger increases in EPS revisions over the last year compared to the Russell 1000 Index as shown in Exhibit 3.

The current 3-month percent change in the 12-month forward EPS estimate (updated weekly) has increased 11.9% for the Russell 2000 in comparison to 6.6% for the Russell 1000.  For additional context, EPS revisions have increased by 7.4% in Asia-Pacific and 5.9% in Europe.

Top-line revisions have also been strongest for the Russell 1000, as the current 3-month percent change in the 12-month forward revenue estimate (updated weekly) has increased 3.7% in comparison to 2.8% for the Russell 1000.  Revenue revisions have increased by 1.8% in Europe and 1.6% in Asia-Pacific.

Exhibit 3: EPS Earnings Revision

If we want to get a closer look at analyst revisions at a more granular level, we can utilize the Aggregates app in Refinitiv Eikon.  Exhibit 4 highlights the StarMine Analyst Revision Model (ARM) model scores at an industry level for the Russell 2000.

The ARM model is a stock ranking model that is designed to predict future changes in analyst sentiment by looking at changes in estimates across EPS, EBITDA, Revenue, and Recommendations over multiple time periods.

Re-opening beneficiaries such as retail, leisure products, and hotels & restaurants are amongst the industries with the highest ARM rank.  Higher levels of e-commerce sales, with their associated shipping costs, have also benefited the air freight and logistics industry, which has an ARM score of 79.

What is more encouraging is that the industries with the highest ARM rank also have very strong Combined Alpha Model (CAM) scores.  CAM combines all available StarMine alpha models in an optimal, static, linear combination.

Exhibit 4: StarMine Model Scores for Russell 2000


Source: Refinitiv Eikon.

With higher analyst revisions in small-caps, the Russell 2000 index is also expected to see significantly higher YoY earnings growth vs. the Russell 1000 as shown in Exhibit 5.  21Q2 preferred earnings growth for the Russell 2000 is currently 258.7% and is expected to further increase to 329.5% in 21Q3 which is likely to be ‘peak earnings’.  This compares to 21Q2 and 21Q3 earnings growth of 73.6% and 26.6% for the Russell 1000.

Within the Russell 2000, Cyclical and value sectors including Materials (+1121.2%), Industrials (+197.2%), Consumer Discretionary (+298.3%), and Energy (+111.8%) are expected to have the largest year-over-year earnings growth.  From an earnings contribution perspective, Energy (52.6 ppt), Consumer Discretionary (50.9 ppt), Health Care (36.2 ppt), and Financials (28.3 ppt) are currently expected to have the largest percentage point contribution (ppt) towards the current index growth rate of 258.7%.

Exhibit 5: Earnings/Revenue Growth for Russell 1000/2000

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