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By Miles Lewis - December 2019
Small-cap value investing historically has been a strong source of returns over the long term. However, it has struggled in recent periods as large-cap growth has been in favor. This does not discourage my team, though, because we’re finding high-quality stocks trading at some of their most attractive prices in years.
In my latest video, I discuss key headwinds holding back small-cap companies’ performance. These include fears of a slowing economy, a potential recession and the extended trade war with China. I also give examples of underlying trends that we believe will ultimately benefit some businesses.
Watch my video to hear more about the opportunities my team is seeing and the outlook for the months ahead.
It's been a difficult year for small caps for sure. They have trailed large caps by about a thousand basis points (10%) over the trailing 12 months, and the reason for that is really unfair of a, a slowing economy and potentially a recession. But the silver lining in that, in that under-performance is that has created some interesting opportunities in small caps.
The valuations relative to large caps are very attractive. Historically, small-cap stocks stayed at about a 20 to 30% premium to large caps, and today they're trading at about parity and that's pretty unusual from a valuation perspective.
Another interesting dynamic that is playing out in the small-cap market is the potential change in leadership from growth stocks to value stocks. Growth stocks have outperformed value stocks for the better part of a decade. Over the last month, however, we've seen value stocks outperform growth stocks by more than 500 basis points, and we don't know if that's necessarily sustainable because we have seen a few of these head fakes this cycle where value has started to outperform.
But the one thing that small-cap value stocks do have in their favor right now is valuation. The spread between growth and value is extremely extended. Small-cap growth stocks are trading at 41 times forward earnings by comparison, small-cap value stocks are trading at a more reasonable 15 times earnings.
There has been a narrative within the market that small caps are more well-insulated than other companies from a trade war and that may have been true very early on, but the reality is, and we felt this way for a while, that it would eventually trickled down to small caps. And we've started to see that and have seen it in some spaces for several quarters now. The silver lining in this of course, is that those companies where the fundamentals have deteriorated have already begun to price in a lot of that and so that does create opportunities for long-term investors.
One example of that would be the technology space. So there are companies that have clearly been exposed and hit because of the trade war issues. But we think that there are underlying technological trends or shifts that are happening that are going to benefit those companies regardless of whether or not we're in a trade war.
A couple of examples of these technological trends would be the shift from LED screens and smartphones to OLED screens, or the shift to 5G networks in the United States. And so, these technological trends are going to continue apace whether or not we're in a trade war with China, and we think that provides an opportunity to own what we believe are really high-quality companies that are going to do well because of these technological trends. We have an administration that may be doing things for reasons that we don't fully understand.
And so, I think our belief is that ultimately, there are things that have to get fixed and the way we do trade with China. The way we're going about them is debatable. But we do think that we get to an agreement at some point because that's not only good for us, but it's good for China and it's good for global GDP (gross domestic product). The persistence of this and how far it's gone has been a bit surprising. But like I said earlier, it's creating opportunities for us.
The outlook for small-cap companies and how they're thinking about the rest of 2019 and beyond really depends on the type of company you're talking to. So, if you're talking to a company in the tech space or the industrial space, a lot of those companies are seeing very defined weakness in their businesses, and they attribute it to trade wars. If you're talking to a company that's more exposed to the U.S. consumer, for example, they seem much more optimistic about their businesses because the U.S. consumer is holding up fairly well right now. Though, one could argue that the consumer is a bit of a lagging indicator, and they will feel the pain at some point.
Get additional insights in our latest Investment Outlook.
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Value Portfolio Manager Mike Liss sees pockets of opportunities in four areas—provided social media and inflation don’t disrupt markets.
Portfolio Manager Miles Lewis explains how his team seeks small-cap companies that may benefit from shifting trends, regardless of the trade war.
Historically, small- and/or mid-cap stocks have been more volatile than the stock of larger, more-established companies. Smaller companies may have limited resources, product lines and markets, and their securities may trade less frequently and in more limited volumes than the securities of larger companies.
Investment return and principal value of security investments will fluctuate. The value at the time of redemption may be more or less than the original cost. Past performance is no guarantee of future results.
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.
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