It seems as if investors fishing for those smaller-but-faster-growing companies—the ones with the potential to disrupt businesses and, possibly, deliver a long runway of outsized earnings growth—have been coming up empty. But now is not the time to cut bait on small-cap growth as an investment style. It remains an important component of a diversified equities portfolio, and the current environment might be setting up to invest in the dynamic small-cap growth asset class opportunistically.

Consider what has transpired since the approval of COVID-19 vaccines in November 2020. Market leadership has shifted away from companies with exciting long-term growth prospects to areas hardest hit during the shutdown, such as travel & leisure, industrials and energy-related companies.

This was especially prevalent within the small-cap universe where slower-growing cyclical companies have been outperforming faster-growing secular growth companies. For evidence, look no further than the Russell 2000® Growth Index, where those companies with earnings growth expectations of greater than 20% materially underperformed stocks with earnings growth expectations of less than 20% during 2021. 

Although we find it odd that many companies with the brightest long-term prospects have underperformed last year, we continue to favor these names within the small-cap universe given their strong fundamentals and, now, relative valuations that may be at generationally cheap levels compared to their larger cap counterparts. As of the end of January 2022, the forward P/E ratio of small secular growth companies (excluding those companies that do not yet have earnings) was at more than a 30% discount compared to their small-cap cyclical growth counterparts in the Russell 1000® Growth Index. That is the largest relative valuation gap since Russell indices incepted in 1979.

Moreover, the attractive fundamentals for many of these growth companies have not changed in our opinion. What has changed, however, is sentiment and valuation. This could reflect any number of factors. Cyclical small-caps may have been perceived as initially offering better value, especially since so many had been beaten down during the earlier days of the pandemic. Given recent performance, however, that relative discount for cyclical growth companies has long passed. 

Another reason often cited for investors eschewing small secular-growth companies is the expectation for higher interest rates. However, this disregards the reality that many small companies also may have solid balance sheets, savvy managements, and the potential to grow top line revenue and bottom line earnings to more than offset any impact from higher interest rates. In fact, many nimble and innovative companies should be able to press their advantages regardless of the interest rate environment.

So while the past year has favored slower-growing cyclical companies within the small-cap universe, there now appears to be an opportunity for small-cap growth stock pickers to acquire faster-growing secular growth companies at a relative discount. 

This could include companies with strong secular growth prospects that have been overlooked or punished in the most recent period, including biotechnology and software companies. Biotechnology is a specific area worth mentioning. Virtually the entire sector has struggled over the past year even though many of these innovative companies have promising drugs in the pipeline. This might reflect the fact that many such companies do not yet have earnings, though this is not uncommon for early-stage companies in the sector. One of the only metrics available to value these biotech companies is enterprise value (a measure of a company's total value) to cash ratio. Based on this metric, non-earning biotech companies within the Russell 2000® Growth Index have been hovering near their lowest valuations ever. Yet it’s important to emphasize that many of these companies continue to make ground-breaking advancements, and nothing may have changed with their long-term potential despite radically underperforming in 2021. Investors should consider whether now is an appropriate time to add these types of small-cap secular growth companies to their portfolio.

Eventually, we expect leadership within the Russell 2000® Growth Index to revert to the set of disruptive tech, healthcare and other companies that have lagged in 2021 and early 2022. And when sentiment changes, investors who stuck with the fastest growing small-cap growth companies with the best fundamentals may be happy they didn’t cut bait.