No doubt investors are acutely aware of the incredible, recent success of large-cap growth stocks. The largest domestic companies have been the key driver of stock market returns over the past several years—at least through the first half of 2024. It’s easy to understand why so many investors have been laser-focused on the “Magnificent Seven,” along with all things related to artificial intelligence.

But given the combination of lofty valuations and heightened economic uncertainty, investors are becoming less enamored by growth and momentum, and more interested in the mundane (things like cash flow and downside risk). It looks like a sustainable rotation away from mega-cap growth and toward smaller, lesser-known companies is underway. For any investors participating in this rotation or otherwise rebalancing, we think it’s critical to differentiate among the various small-cap value approaches.

The Base Case

One of the catalysts driving the rotation toward small caps and value strategies is the expectation that the Federal Reserve will finally begin easing monetary conditions with rate cuts later this year. Higher-for-Longer may have run its course, particularly after the July employment data spooked the market and suggested that the economy may be slowing more rapidly than previously expected. Any loosening of monetary policy and corresponding reduction in the fed funds rate should ease future borrowing costs.

Moreover, given the performance of large- and mega-cap stocks over the past decade, rarely have small-cap value stocks traded at such a historic discount to their larger cap counterparts. Small cap value stocks, as measured by the Russell 2000 Value Index, are trading at only 13x forward EPS estimates at the start of the third quarter, versus 22x for the broader S&P® 500. Any reversion to the historical mean might provide a nice tailwind to the small cap value asset class.

Remember, market leadership can and will change, even though that may be difficult to fathom after so many years of large-cap growth dominance. In our experience, previous trough valuations of small-cap value have often been followed by periods of outperformance versus larger growth-oriented stocks. One high-profile example was during the peak of the dot-com tech bubble when small-cap value stocks were similarly priced relative to the broader market. The Russell 2000 Value returned approximately 84% from January 3, 2000, to December 31, 2003, while the S&P 500 lost 19% over that same period. The key takeaway, for us, is that investment style-box leadership does change and tends to run in cycles.

Not All Value is Created Equal

Any investor compelled to allocate to small-cap value stocks, whether for their long-term potential or simply to correct a lingering under-allocation, has many options.

However, we would eschew a passive approach for this asset class (no surprise here). We think buying an index forgoes an opportunity to add alpha in an arena where there are more stocks and less sell-side analyst coverage when compared to the world of large caps. Such a dynamic suggests there are potential pricing anomalies and opportunities to identify value overlooked by the broader market. And while a passive approach may cast a wide net, it undoubtedly will capture many names that an investor might not want to pursue. For example, our research shows that of the Russell 2000 Value Index, almost half the constituents had no earnings in the most recent quarter. These stocks are probably not ideal targets of value-oriented investors.

Rather than relying on an index or simply buying stocks because they are cheap, we think there’s a better way. Here are three keys that we believe can lead to compelling and durable small-cap value portfolios:

1. ROIC Focus. We contend that Return on Invested Capital (ROIC) is the essential measure of the value-creating capability of a company. Long-term shareholder value can be built by focusing on companies that manage capital, not earnings, and on businesses that have sustainable, long-term returns that exceed their cost of capital.
2. Structural Change (i.e. Improving ROIC). We like to identify companies undergoing meaningful structural change, such as new leadership, new compensation systems, asset dispositions or other circumstances. In our experience, such structural change tends to be a catalyst for significant improvement in a company’s ROIC, which generally results in a higher multiple for the company’s stock.
3. Managing Downside Risk. One guiding tenet that we believe helps mitigate downside capture is to always consider what can go wrong first. This means adhering to valuation principles and buying as close as possible to our downside price target. We also tend to favor less financially leveraged companies with strong underlying franchise and asset values. And finally, a credit-based approach that looks at the balance sheet first, cash flow second, and the income statement third helps downside protection and avoid value traps, in our opinion. Many value managers tend to do this in reverse order.

There’s no denying that the small-cap value asset class has faced headwinds in recent years; however, we think a rotation may be at hand. But as always, caveats apply. Traditional, value-oriented approaches are often narrowly focused on certain metrics, such as price to earnings (P/E) or price to book value (P/B), as a means to identify low-priced bargains. Yet value investing does not have to be about buying cheap stocks and hoping they become less cheap.

Rather, we find that significant value can be created when companies improve their ROIC, which can ultimately increase cash flow and result in a higher multiple that the market is willing to pay for the business. The potential of a dual benefit of improved cash flow and a higher multiple—while adhering to a valuation discipline and strict risk protocols—seems like a better way to build and manage a small-cap value portfolio.