Win Big By Thinking Small: 4 Reasons Why U.S. Small Cap Value Should Outperform

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Includes: DIA, IWM, QQQ, SPY
by: The Prosperity Active Yield Fund

Summary

Value as a whole is likely to outperform growth over the next five years.

The economy of the United States is robust.

For small caps, low interest rates should continue to spur top line growth, while low commodity prices grow the bottom line.

Small caps are not hindered by the significant headwinds facing large caps like the strong dollar and a weak Europe, Asia, and Emerging Market economies.

Abstract:

In times of intense volatility and foreign instability, investors worry about where to put their money to work. Fear often dictates in situations like these, but - as I will attempt to explain in this article - rational analysis leads to the conclusion that the likely winners in today's market are domestic small capitalization value stocks. This view is based on the following four factors:

  1. Value is about to make a comeback in a big way.
  2. The United States economy is incredibly robust, and getting stronger.
  3. The tailwinds behind small capitalization value stocks of low interest rates and low commodity prices should continue to help accelerate top and bottom line growth, respectively.
  4. The significant headwinds holding back large multinationals like the strong dollar and a weaker Europe, Asia, and Emerging Market economies have little to no effect on domestic small cap value stocks.

1. Value is about to make a comeback in a big way:

As I laid out in much more detail in my article, Value Is About To Make A Comeback In A Big Way, I believe strongly that the next five years will see an outperformance of value over growth. This is based on the following reasons:

  • Value has lagged growth since mid-2010, with the gap widening especially over the past year.
  • Value has been shown to outperform over longer periods of time.
  • Fearful investors will flee expensive growth stocks in anticipation of a market correction.
  • Growth will significantly underperform value in a rising-rate environment.

Growth stocks have been undeniably successful investments over the past five years, and for good reason. However, for the second half of the decade, history suggests (and I anticipate) value is about to make a comeback in a very big way. This viewpoint is not only supported by the well-documented historical outperformance of value versus growth, but also by the eventual shift away from expensive, risky assets by fearful investors anticipating a correction, as well as the ability of value stocks to withstand rising-rate environments significantly better than growth stocks. The market is - at times - irrational, but equity valuations ultimately follow earnings, and the earnings of value companies thus far this decade have been incredibly robust.

After writing that article on August 11th, the market took a turn for the worse. The results were a divergence between value and growth stocks, something I discussed in my article, Value Vs. Growth: The Divergence Is Just The Beginning.

2. The United States economy is incredibly robust, and getting stronger.

Despite fears about the health of our economy due to the Federal Reserve's reservations (pardon the pun) on raising the Fed Funds Rate, the available data suggests a very healthy economy. Since the end of 2009, the unemployment rate has fallen in a controlled, yet significant manner. Having been cut in half since hitting 10% in late 2009, the unemployment rate stands currently at just 5.1% as of August.

(Source: The Bureau of Labor Statistics)

Meanwhile, Productivity has been steadily rising, having risen 3.3% in the 2nd quarter of 2015 with unit labor costs falling 1.4% (Source: The Bureau of Labor Statistics). These are both key positives for U.S. Small Caps.

3. The tailwinds behind small capitalization value stocks of low interest rates and low commodity prices should continue to help accelerate top and bottom line growth, respectively.

Low interest rates facilitates borrowing. For fundamental valuation analysis, the cost of capital is one of the most significant variables in calculating value. In its January 29th, 2014 report, Credit Suisse's Global Financial Strategies department laid out the basic steps for valuing businesses. According to the report,

where:

and:

(Source: Credit Suisse)

Lowering the cost of capital dramatically boosts top line growth by allowing businesses to expand their operations cheaply.

As far as the bottom line is concerned, dirt-cheap commodity prices help in an equally significant fashion.

(Source: FinViz)

Crude oil isn't the only commodity to have taken a beating recently. Gold, silver, platinum, copper and palladium have all fallen dramatically as well.

(

(Source FinViz)

When the prices of necessary expenses like energy and materials fall, profit margins rise - bring a company's bottom line along with.

4. The significant headwinds holding back large multinationals like the strong dollar and a weaker Europe, Asia, and Emerging Market economies have little to no effect on domestic small cap value stocks.

Two significant macroeconomic factors have weighed heavily on large multinational companies recently. These are, of course, the strong dollar and the general weakness of overseas economies.

(Source: FinViz)

^SSEC Chart

^SSEC data by YCharts

These factors may play a temporary role in suppressing market (NYSEARCA:SPY) multiples as a whole, but their effects on domestic, small cap value stocks are minimal and transitory at best.

Takeaway:

Global uncertainty inevitably leads to volatility, and for good reason. Rational investors need not fear, however, because the outlook for small capitalization, domestic value stocks is bright.

Happy Hunting

-Adam Janes, The Prosperity Active Yield Fund

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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