Mid Quarter Update Q4 2020: Small Cap Equity

December 14, 2020

Small caps surge ahead as uncertainties decline

The small cap market, as defined by the Russell 2000 Index, returned 20.9% for the first two months of the fourth quarter of 2020. In particular, November saw the best monthly return on record for small caps with an appreciation of 18.4%. Investor optimism was primarily driven by the conclusion of the US Presidential election, which removed considerable uncertainty surrounding future fiscal policy, and the positive Covid-19 vaccine developments, which led to anticipation of a sooner than expected economic re-opening.

Equity markets have been dominated by large capitalization stocks for so long that the relative performance of the past two months was notable. The Russell 1000 Index returned 9.1%, significantly lagging the Russell 2000 Index’s return of 20.9%. The nature of the stocks that led the way in the small cap index was also of interest. As of November 30, a record 33% of the Russell 2000 Index was comprised of negative earning companies and this cohort of the benchmark outperformed stocks with positive earnings by ~4% in the last two months, 23.7% vs 19.6%.

Similar to what has occurred throughout 2020, the Biotechnology industry was the key driver for the negative earners on an attribution basis , up 26.2% for the two month period. Investor optimism about the prospects for economic re-opening also led to negative earner outperformance in the Airlines, Hotels & Restaurants, and Metals & Mining industry groups. This re-opening trade led to sizeable short term performance gains, but this simply offset the deep year-to-date losses that many of these stocks still show on a performance basis. Questions about the business model viability of many of these companies remain, but investors looked past this for a short term trade in the month of November. As discussed in our recent paper, “Why Profitability Matters”, our strategy deliberately avoids negative earners as their cyclical periods of outperformance tend to be followed by significant share price erosion. Over a longer-time frame, stocks with positive earnings have been a superior investable group.

The portfolio returned 19.8% (19.6% net) for the first two months of the fourth quarter, which was an underperformance of 1.1% on a gross of fee basis relative to the Russell 2000 Index. The portfolio's underweight to the outperforming non-earner group, particularly in Health Care and Materials, led to the performance shortfall. However, strong stock selection in Financials was a bright spot in the portfolio for the period.

The portfolio’s Health Care sector was down -1.0% relative to the benchmark on an attribution basis. The underperformance was primarily driven by the portfolio’s lack of exposure to the highest growing industry groups such as biotech and health care technology. These stocks continue to draw investor interest in “risk on” periods given their recent positive returns, despite a more challenged fundamental future. Additionally, these industry groups are dominated by profitless companies which tend to be poor investments over the long term. The portfolio is, therefore, underweight the group.

The Materials sector detracted -0.6% on an attribution basis. The portfolio maintains an underweight to the sector given the earnings challenges faced by these economically sensitive companies. Investor optimism about an economic re-opening led to many of these depressed issues, particularly in the chemical and packaging industries, significantly outperforming. The portfolio investments tended to be of higher quality, and therefore less speculative, and they did not keep pace in the torrid return environment of last two months. 

The portfolio’s Financials sector added 1.8% on an attribution basis for the quarter. The strategy benefited strong stock selection, specifically within the banks industry. Banks should benefit from higher loan growth as the economy reopens and borrowers feel more comfortable taking on debt in order to fund spending and investment. Additionally, a steepening yield curve should allow for banks to lend more profitably than in recent years.

Significant economic recovery from the recent lows combined with commitments from global central banks that monetary policies will remain accommodative for some time provided the underpinnings for a potential surge in asset prices. The Covid-19 vaccine developments and the clearing of the US election provided the catalysts for the “everything rally” of the last two months. Equity markets have been dominated by large capitalization technology issues for an extended period so a catch up trade in some of the more neglected industries was bound to be violent, and this is what occurred. It is important, however, to recognize that many of these moves are not based on fundamentals, but instead on investor positioning mismatches. It is likely that there will be many false starts as equity leadership shifts to better represent the emerging economic cycle. In this environment we believe that our investment philosophy still holds true: higherquality companies trading at attractive valuations with company specific catalysts should outperform.


The views expressed represent the opinions of the portfolio managers as of November 30, 2020. There can be no assurance that the same factors would result in the same decisions being made in the future. In addition, the views are not intended as a recommendation of any security, sector or product. Returns reported represent past performance and are not indicative of future results. Actual performance may be lower or higher than the performance set forth above. For institutional adviser use only, not intended to be shared with retail clients.