Below is the latest commentary from Rothschild Asset Management Inc., the subadvisor to Pacific FundsSM U.S. Equity Funds.

In recent years, product innovation has allowed investors and their advisors access to a variety of new asset classes previously limited to institutional investors. Yet, with all the recent discussion of relatively modern techniques, somewhat underappreciated is the potential benefit of including small-cap growth in investors’ portfolios.  Over the long term, having exposure to the most innovative sectors and companies within the U.S. market offers diversification and the possibility of enhanced returns.
 

Key Takeaways

  • Small-cap stocks have fundamentally different characteristics from large-cap stocks. Smaller companies are more likely to be domestically-oriented and less reliant on debt.

  • Because of greater differentiation among companies and fewer analysts covering small-cap stocks, the small-cap universe is less efficient, giving active management a chance to add value.

  • Small-cap growth and disciplined investing need not be mutually exclusive: incorporating a thoughtful approach can drive strong long-term relative returns with lower than market risk.

  • Small-cap growth offers investors a time-tested means to harness innovation while delivering diversification and a possibility of enhanced returns over the long term.

 

Not Just Smaller, But Different

Small-cap stocks (those with $3 billion or less in market capitalization) are not bite-size versions of their large-cap peers, but actually tend to have fundamentally different characteristics. They are more likely to be domestically-oriented and often less reliant on debt to finance their operations. So at a time when the U.S. dollar is strong and interest rates are expected to rise, small-cap companies could have a relative advantage to large-cap companies.

Larger firms that are struggling to grow organically have the ability to consolidate small-cap companies with higher growth profiles. In addition, research from Credit Suisse shows that valuations of small-cap stocks relative to large-caps stocks are “the most compelling since the tech bubble.”1 Such attractive valuations not only allow for multiple expansion, but could also fuel interest from large-cap companies in lower capitalization names. Over the past 10 years, on average, 6% (more than 100 companies) of the small-cap universe was acquired annually, at a median premium of 25%.2 Almost 55% of the small-cap acquisitions were in the Health Care, Information Technology, and Consumer Discretionary sectors, at a median premium of 27%.3

Historically, small-cap stocks have also provided fertile ground for active management.   While the average large-cap stock has more than 20 sell-side analysts4 covering it, the average small-cap stock has just six.5 Moreover, 15% of small-cap stocks are covered by only one or two analysts, and 7% have no coverage at all.6

Furthermore, due to the heterogeneous nature of the small-cap universe, there tends to be a greater divergence between the “haves” and “have-nots” than in the large-cap segment. By the time a company has “made it big,” it has likely established a strong market position and honed operations including supplier logistics, distribution, and marketing of products and services. In the small-cap space, however, companies may still be facing these issues, with significant variation from firm to firm. For these reasons, the small-cap segment remains inefficient, creating an opportunity for active management to add value.

 

The Future Is Growth

While the previously mentioned factors are common to all small-cap stocks, there are additional factors unique to the small-cap growth universe. Ultimately, a key distinction between small-cap growth and value asset classes is in sector exposures, with stocks in the Health Care, Information Technology, and Consumer Discretionary sectors offering high growth compared to more interest-rate sensitive sectors, such as Financials and Utilities, as well as the Real Estate Investment Trust (REIT) industry.

Sector Composition: Small-Cap Growth vs. Small-Cap Value

While the vast majority of the small-cap growth index is comprised of “classic growth” sectors (Health Care, Information Technology, and Consumer Discretionary), just 24.3% of the small-cap value index is comprised of these sectors. Conversely, over half of the small-cap value index is comprised of lower-growth sectors (Financials and Utilities).

  Russell 2000®
Growth Index
Russell 2000®
Value Index
Information Technology 24.8% 10.5%
Health Care 23.6% 4.1%
Consumer Discretionary 18.1% 9.8%
Industrials 13.9% 11.9%
Financials 8.4% 42.8%
Materials 4.2% 3.4%
Consumer Staples 3.5% 3.6%
Cash and Other 1.6% 2.2%
Energy 1.0% 3.4%
Telecommunication Services
0.9% 0.9%
Utilities 0.1% 7.6%

Combined Exposure to
Health Care, Information Technology, and Consumer Discretionary
  66.5% 24.3%

Combined Exposure to Financials, REITs, and Utilities
  9.3% 50.3%

Source: FactSet, Russell as of March 31, 2016.
 

For various structural reasons, companies in the Health Care and Information Technology sectors have benefited from long-term growth drivers. In these sectors, innovation is not a pipe dream, but a reality. Today, personalized medicine is revolutionizing healthcare, with biotech research leading to cures for diseases. A watershed moment for these advances came with the mapping of the human genome, largely completed by 2003. Sequencing the euchromatic regions of the genome allowed for more targeted and effective treatments. For example, recognizing the advanced technology that Pharmasset Inc., a development stage biotechnology company, had developed for treating hepatitis C, Gilead Sciences Inc. paid approximately $11 billion—almost a 90% premium—to acquire the company.  Today, the drug is commercially available and curing patients who have the Hepatitis C virus.   

Technological innovation is no longer just the stuff of futuristic sci-fi movies, but has manifested itself through the Internet of Things7, wearables, and unified communications. These advances, along with security, cloud computing, and software-defined networks are all disruptors and drivers of growth. Firms such as Fitbit (the maker of wearable health and fitness monitoring devices) and Nest (a maker of Wi-Fi enabled thermostats and other home automation products) are allowing us to collect information on the fly to improve our health and quality of life. That being said, not every technological innovation actually results in strong stock performance; companies may fail to execute, and even the latest technology can be leapfrogged by the next big thing.  Therefore, stock selection is critical in driving consistent relative performance.

In addition to these structural drivers, there are a few cyclical drivers supporting small-cap growth stocks. The current strengthening of employment and wage growth, coupled with lower gas prices, could fuel stocks in the Consumer Discretionary sector, which also represent a significant portion of the small-cap growth universe. In addition, recent research from Goldman Sachs demonstrates that operating margins for small-cap stocks are near trough levels relative to history. In growth-oriented sectors, recent operating margins for stocks in the Health Care sector stood at –3.9% versus a 10-year median of –0.9%; recent margins in the Information Technology sector stood at 2.5% versus a 10-year median of 3.5%. This data suggests that these companies are “under-earning” relative to long-term trends and have potential margin levers to pull in a weaker economic environment.

 

A Measured Approach

We believe that small-cap growth investing should not be equated with early-stage venture capital investing, or growth-at-any-price strategies. Importantly, growth and disciplined investing need not be mutually exclusive; incorporating a thoughtful approach may drive strong long-term relative returns with lower than market risk.

Small-cap growth stocks vary widely in terms of their financial health and other company-specific characteristics, as stocks in the Health Care, Information Technology, and Consumer Discretionary sectors typically have more idiosyncratic fundamental drivers. Small-cap growth companies can often grow market share—and the bottom line—even when the economy itself is sluggish. Still during a downturn, a small-cap growth company with 2% market share and significant advantages (superior pricing, technology, etc.) could realistically double or triple its slice of the pie. Conversely, such gains are more difficult for a large-cap growth company already enjoying a 40% or 50% market share.

Under-Earning: Selected Russell 2000 Index Sectors Operating Margins vs. Long-Term Averages

  Current Operating
Margin
10-Year Median
Operating Margin
Health Care –3.9% –0.9%
Materials 0.8% 3.3%
Information Technology 2.5% 3.5%
Energy –8.7% –0.4%
Consumer Staples 2.5% 2.2%
Industrials 3.7% 3.8%
Telecommunications 4.1% –0.9%
Consumer Discretionary 3.4% 2.4%
Russell 2000 Index 1.5% 2.6%

Source: Compustat, Goldman Sachs Global Investment Research, September 30, 2015.

 

Data from Morningstar® shows that assets in Large-Cap Growth funds dwarf the amount in Small-Cap Growth funds. As of February 2016, more than $1.25 trillion was invested in Large-Cap Growth funds versus just $174 billion in Small-Cap Growth funds. In other words, investors are allocated more than 7-to-1 on average to Large-Cap Growth funds, despite the fact that the Russell 2000® Growth Index has outperformed the Russell 1000® Growth Index (the common benchmarks for small-cap growth and large-cap growth funds, respectively) in eight out of the past 11 rolling five-year periods. As much as any structural factors, such consistent outperformance argues that small-cap growth may have a place in investors’ portfolios.

Investors and their advisors are increasingly searching for better ways to construct portfolios, and innovation should be a part of that exercise. While diversification and risk management are key considerations for any portfolio, investors are increasingly searching for ways to build assets in a low-return environment. Small-cap growth offers investors a time-tested means to harness innovation while delivering diversification and a possibility of enhanced returns over the long term.

Small-Cap Growth vs. Large-cap Growth: Consistency through Five-Year Rolling Returns

Returns (Annualized) Group/Investment
Small-Cap Growth Large-Cap Growth†† Small-Cap Growth outperforms if positive
2001 - 2005 2.28 –3.58 5.86
2002 - 2006 6.93 2.69 4.24
2003 - 2007 16.50 12.11 4.39
2004 - 2008 –2.35 –3.42 1.07
2005 - 2009 0.87 1.63 –0.76
2006 - 2010 5.30 3.75 1.55
2007 - 2011 2.09 2.50 –0.41
2008 - 2012 3.49 3.12 0.37
2009 - 2013 22.58 20.39 2.19
2010 - 2014 16.80 15.81 0.99
2011 - 2015 10.67 13.53 –2.86

  These time periods are the exception (Small-Cap Growth did not outperform when positive).

As represented by the Russell 2000® Growth Index.
†† As represented by the Russell 1000® Growth Index.

Source: Morningstar Direct.

DP1

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, when redeemed, may be worth more or less than the original cost.


• • •

1 January in a Nutshell,” Credit Suisse, February 2016.
2
Rothschild analysis using FactSet data, March 2016.
3
Ibid.
4 A sell-side analyst evaluates companies for future earnings growth and other investment criteria.
5 Rothschild analysis using FactSet data, March 2016.
Ibid.
7
The network of physical objects—devices, vehicles, buildings and other items—embedded with electronics, software, sensors, and network connectivity that enables these objects to collect and exchange data.
 

Rothschild Asset Management Inc.
Headquartered in New York, Rothschild Asset Management Inc., and its affiliates, manage investments covering a range of alternative investments, multi-strategy fund of hedge funds, and U.S. securities including large-cap, small/mid-cap, small-cap, and growth and value strategies. The firm believes in investing with a goal of consistency and risk control. Every step in its process is a means toward achieving that goal. Its asset management business provides investment management and advisory services to institutional clients, financial intermediaries, and private clients around the world.

 

Definitions

The Russell 2000® Index is a small-cap stock market index of the bottom 2,000 stocks in the Russell 3000® Index.

The Russell 1000® Index is a stock market index that represents the highest-ranking 1,000 stocks in the Russell 3000® Index, which represents about 90% of the total market capitalization of that index.

The Russell 2000® Growth Index measures the performance of the small-cap growth segment of the U.S. equity universe. It includes those Russell 2000 companies with higher price-to-value ratios and higher forecasted growth values.

The Russell 2000® Value Index measures the performance of small-cap value segment of the U.S. equity universe. It includes those Russell 2000 companies with lower price-to-book ratios and lower forecasted growth values.

 

This publication is provided by Pacific Funds. These views represent the opinions of Rothschild Asset Management Inc. and are presented for informational purposes only. These views should not be construed as investment advice, the offer or sale of any investment, or to predict performance of any investment. All material is compiled from sources believed to be reliable, but accuracy cannot be guaranteed. The opinions expressed herein are based on current market conditions, are as of May 2016, and are subject to change without notice.

As with any mutual fund, the value of the Fund’s holdings will fluctuate so that shares, when redeemed, may be worth more or less than their original cost. 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, in response to many factors, including a company’s historical and prospective earnings, the value of its assets, general economic conditions, interest rates, investor perceptions, and market liquidity. Small-capitalization companies may be more susceptible to liquidity risk and price volatility risk and more vulnerable to economic, market, and industry changes than larger, more established companies. Growth companies have the potential for above-average or rapid growth, but may be subject to greater price volatility risk than investments in “undervalued” companies. Value companies are those that are thought to be undervalued and perceived as trading for less than their intrinsic values. There is a risk that the determination that a stock is undervalued is not correct or is not recognized in the market.

Diversification and asset allocation do not guarantee future results, ensure a profit, or prevent loss.

Sector names in the commentary are provided by the Funds' portfolio managers and could be different if provided by a third party.

PFD2

You 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.

Rothschild Asset Management Inc. is not affiliated with Pacific Life Insurance Company.

Third-party trademarks and service marks are the property of their respective owners.

PSD2

Mutual funds are offered by Pacific Funds. Pacific Funds are distributed by Pacific Select Distributors, LLC (member FINRA & SIPC), a subsidiary of Pacific Life Insurance Company (Newport Beach, CA), and are available through licensed third parties. Pacific Funds refers to Pacific Funds Series Trust.

AM6

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