Sam Masemer, CFA
Client Portfolio Manager
In an investment world captivated by tech advancements and medical breakthroughs, small-cap value stocks may be overlooked due to their overweight in old-guard sectors such as financials and real estate. We believe now is the time to reexamine the “value” in adding small-cap value stocks to an equity portfolio and the potential benefits they may provide to an asset allocation mix.
Thinking Inside the Box
When people pay for goods—whether it be groceries, a new car, or a stock—they want to feel that they are getting their money’s worth. Within U.S. equities, small-cap value stocks provide that feeling for us. When comparing price-to-earnings, price-to-book value, and price-to-cash flows ratios, small-cap value stocks are currently trading for less than the asset classes represented by the other eight equity style boxes.
Source: Morningstar®, as of 9/30/19
Digging a little deeper and comparing small-cap value versus small-cap growth, various metrics show how small-cap value stocks can be less expensive than small-cap growth counterparts.
Source: Russell®, as of 9/30/19
Historical Returns of Small-Cap Value Versus Small-Cap Growth
Over the last 20 years, year-over-year performance between small-cap value and small-cap growth has varied greatly. Since 1999, small-cap value had better annual returns nine of the 20 years, while small-cap growth had the better performance 11 of the 20 years. But in years when small-cap value outperformed, its average excess return was 11.3% above small-cap growth. When small-cap growth outperformed, its average excess return was 6.9% above small-cap value.
Chart 3: Excess Returns in Periods of Outperformance
Source: Morningstar, as of 9/30/19
While performance of small-cap value versus growth is impossible to predict, small-cap growth has outperformed value in eight of the last 10 years. However, from 1999 to 2008, value outperformed growth seven out of 10 years. Interestingly, small-cap value outperformance came when investors needed it most. During the 2000–2002 bear market and the 2008 global financial crisis, small-cap value outperformed small-cap growth.
Chart 4: Small-Cap Value versus Small-Cap Growth in Bear Markets
Source: Russell, as of 9/30/19
Diversification Benefits of Small-Cap Value
Large-cap growth stocks are likely to be found in many investors’ portfolios given the robust tailwinds growth has had during the longest recovery in U.S. history. Small-cap value stocks have the lowest correlation to large-cap growth stocks of all U.S. equity small-cap style boxes. With large established companies such as Visa or Microsoft, attracting investors because of growth potential, a sleeve of small-cap value injects a different investment profile into an asset-allocation mix.
Chart 5: 3-Year Correlation to S&P 500 index®/3-Year Correlation to Large-Cap Growth
Source: Morningstar, as of 9/30/19
Our Bottom Line
Equity styles ebb and flow. Small-cap value stocks typically underperformed growth at the beginning of a market cycle. However, given some of the headwinds investors have experienced in recent years, we believe at this later stage of the cycle, small-cap value can potentially benefit a portfolio. First, for investors who are considering domestic equities trading at attractive multiples, small-cap value is the least expensive asset class among U.S. equity style boxes. Second, small-cap value has historically held up better in bear markets than small-cap growth stocks. And finally, small-cap value stocks can provide differentiated returns compared to other U.S. equity asset classes, potentially helping investors with diversification.
Pacific FundsSM Small-Cap Value
◾ Rothschild & Co’s process allows managers to hold companies they believe have good expectational upside relative to the market as they move along the market-capitalization spectrum.
◾ The Fund seeks to provide both long-term capital appreciation and a controlled level of risk in down markets.
◾ Under normal circumstances, the Fund invests at least 80% of its assets in common stocks and other equity securities of small-capitalization U.S. companies.
Rothschild & Co Asset Management US Inc. (Rothschild & Co) is the subadviser to Pacific Funds Small-Cap Value and the rest of the Pacific FundsSM U.S. Equity Funds lineup.
Advisor Class Performance as of September 30, 2019
For performance data current to the most recent month-end, call Pacific Funds at (800) 722-2333, or go to PacificFunds.com/Performance. Performance data quoted represents past performance, which does not guarantee future results. Current performance may be lower or higher than the performance quoted. The investment return and principal value of an investment will fluctuate so that shares, when redeemed, may be worth more or less than the original cost.
Advisor Class shares incepted on 1/11/16. Effective 8/1/19 through 7/31/20, net (reflects waivers, reductions, reimbursements, and the limitation of certain “Other Expenses”) and gross (reflects the total annual operating expenses) expense ratios are 0.95% and 1.32%, respectively. The Fund acquired the assets of the Rothschild U.S. Small-Cap Value Fund (the Predecessor Fund) in a reorganization transaction on 1/11/16. The Fund’s objectives (goals), policies, guidelines, and restrictions are substantially the same as those of the Predecessor Fund. The performance figures shown for Advisor Class shares of the Fund reflect the historical performance of the then-existing Institutional Class shares of the Predecessor Fund for periods prior to 1/11/16. The performance figures for periods prior to 1/11/16 have not been adjusted to reflect fees and expenses of Advisor Class shares of the Fund. If these returns had been adjusted, then performance for the share classes could vary from the returns shown based on differences in their fee and expense structures. The Institutional Class shares of the Predecessor Fund commenced operations on 12/31/14.
About Principal Risks: All investing involves risk, including the possible loss of the principal amount invested. There is no guarantee that the Fund will achieve its investment goal. Equity securities tend to go up or down in value, sometimes rapidly and unpredictably. Small-capitalization companies may be more susceptible to liquidity risk and price volatility risk, and be more vulnerable to economic, market, and industry changes than larger, more established companies. Value companies are those that a manager believes are undervalued and trading for less than their intrinsic values.
Past performance does not guarantee future results. Diversification does not ensure a profit or protect against loss.
Pacific Life Insurance Company is the administrator for Pacific Funds. It is not a fiduciary and therefore does not give advice or make recommendations regarding insurance or investment products.
Investors should consider a fund's investment goal, risks, charges, and expenses carefully before investing. The prospectus and/or the applicable summary prospectus contain this and other information about the fund and are available from your financial advisor. The prospectus and/or summary prospectus should be read carefully before investing.
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Rothschild & Co Asset Management US Inc. is unaffiliated with Pacific Life Insurance Company.
No bank guarantee • May lose value • Not FDIC insured