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5 Questions about the Stellar Year in Small Caps

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Many investors view small-cap stocks opportunistically, moving into and out of the asset class in pursuit of short-term gains. In light of the recent small-cap rally, investors may be wondering whether it’s too late to invest in small caps or if it’s time to get out. This way of thinking may be losing sight of the bigger picture. Small-cap companies can outperform large companies as they did in 2016, but they can also underperform, sometimes significantly. Because we don’t know when small- or large-cap stocks will outperform, exposure to both asset classes may make sense. Kayne Anderson Rudnick (KAR) takes a long-term approach to the small-cap portfolios it manages, focusing on high-quality companies that have demonstrated consistent growth during both good and bad markets. In the following Q&A, KAR Chief Investment Officer Doug Foreman discusses the current small-cap market.

Related Resource:

Quiet Power of Quality  – A look at why an inefficient market can create an opportunity to generate alpha; how small-cap stocks have historically diversified portfolios; and why Kayne Anderson Rudnick believe it’s always a good time to own small caps, and to hold them for the long term.

A Q&A with Kayne CIO Doug Foreman, CFA

This year, small-cap stocks have been the darling of the equity market, with the Russell 2000® Index up about 20% year to date.1 The small-cap run was first trigged by signs of improved economic growth over the summer, and then ignited by the surprise election of Donald Trump, whose pro-business economic proposals, including a reduction of corporate and personal taxes, a repeal of Obamacare, and increased infrastructure spending, have generated excitement among investors. President-elect Trump's election platform also called for less regulation, more protectionism, and global trade tariffs, which could negatively impact multinational corporations more so than smaller, domestic companies.

With heightened interest in small-cap stocks, we've fielded a number of questions from investors about the recent rally, which we address below.

1. Why are small-cap stocks outperforming this year?

Even before the election, small-cap stocks were doing well, spurred on by several positive indicators of economic growth. Through election day on November 8, the Russell 2000 was up 6.5% this year.1 Among the economic indicators that bode well for smaller companies are the inventory-sales ratio, which peaked in early 2016 at 1.41,2 indicating that companies were turning over their excess inventory, a potential tailwind for U.S. growth. In addition, industrial production slowed at a lesser pace, contracting at 0.6% in November.3 Commodity prices also stabilized in 2016 after hitting a low in January.1 In particular, crude oil finally found a bottom.

Small-cap stocks received another boost from Trump's victory, as the combination of a pro-business Trump presidency and a Republican-controlled Congress led investors to move further into small caps, as both the executive and legislative branch would now be committed to less regulatory oversight and lower corporate taxes. This particularly benefits bank stocks, which represent a large portion of the Russell 2000. The Russell 2000® Value Index, which measures U.S. stocks in the equity value segment and has a heavy weight in the banking sector as well, is up more than 32% year to date.1 In addition, investors are also betting that smaller companies will benefit more than larger, multinational companies, whose large foreign operations could be hurt by a rising dollar and Trump's protectionist approach to global trade.

2. Which sectors have contributed the most to the small-cap rally?

In addition to the run up in the banking sector, several other sectors have contributed to the outperformance of small caps this year, including:

Industrials/Materials: One of Trump's largest priorities is to spend substantially on U.S. infrastructure, which should benefit metals and manufacturing companies, which are up 25% and 20%, respectively, since the election.1

Energy: Energy stocks on the Russell 2000 are up 27% since the election, likely brought on by climbing oil prices due to the potential improvement in the outlook for global excess oil supply.1

Health Care: Given Trump's repeated pledge to "repeal and replace" the Affordable Care Act, better known as "Obamacare," small health care companies have received a boost since the election, as investors are betting that a Trump presidency will mean less regulation and less pricing pressure on pharmaceutical companies and health insurers. Biotechnology companies, which are heavily weighted in the Russell 2000, have also benefited from the latest small-cap rally.

Consumer Discretionary: The consumer discretionary sector has been up 13% on the Russell 2000 since the election, as investors are banking that Trump's plan to lower taxes for corporations and individuals could increase consumer spending, which would benefit specialty retailers.1

3. With the U.S. Federal Reserve expected to raise interest rates three times next year, what is the potential impact on small-cap stocks?

Conventional wisdom holds that since smaller companies generally need more external capital to grow than larger companies, they will be more negatively affected by rising interest rates. In actuality, small-cap stocks have tended to perform better than larger companies during rising rate environments as larger, multinational companies often post diminished returns due to a stronger U.S. dollar, which makes exports more expensive. What's more, rising rates generally signal that the economy is expanding, which typically benefits smaller companies. No one knows for sure whether small-cap stocks will be able to continue their record run throughout next year. That's why we believe it's still important to invest in companies with consistent and profitable growth, high returns on capital, strong free cash flow, and a low organic need for external financing.

4. Should I adjust my portfolio to align more with businesses that stand to benefit from President-elect Trump's proposals?

Many of Trump's proposals are just that — proposals — and have yet to be enacted. We need more evidence about which actual policies might come to fruition before making any major portfolio changes. Overall, you shouldn't feel compelled to radically change your portfolio due to your long-term strategic positioning.

As long-term investors, we have high-conviction about the names we invest in and are not swayed by daily market fluctuations, which are often based on short-term speculation and not company fundamentals. For now, we believe investors should sit tight and see how the President-elect works with Congress and what type of global agenda he proposes before they make any meaningful portfolio adjustments.

5. How long will small caps continue to outperform?

In the short-term, we believe the likelihood that small caps will outperform is strong, as many investors are rotating out of bond funds and rotating into equities — as typically happens during the back half of a bull market. What's more, investors who were on the sidelines with cash in anticipation of a market decline due to the election had to buy back into the market following Trump's victory because their timing effort didn't work. We expect small-cap stocks to continue to outperform in the near term, as many investors attempt to gain exposure to surging small-cap indices. Over the long term, we remain committed to quality companies with sound fundamentals.

Doug Foreman, CFA
Chief Investment Officer

Investment Partner
Kayne Anderson Rudnick Investment Management, LLC Logo

1.FactSet, as of 12/23/16
2.Federal Reserve Bank of St. Louis
3.Trading Economics

Past performance is not a guarantee of future results.

Virtus Investment Partners provides this communication as a matter of general information. The opinions stated herein are those of the author and not necessarily the opinions of Virtus, its affiliates or its subadvisers. Portfolio managers at Virtus make investment decisions in accordance with specific client guidelines and restrictions. As a result, client accounts may differ in strategy and composition from the information presented herein. Any facts and statistics quoted are from sources believed to be reliable, but they may be incomplete or condensed and we do not guarantee their accuracy. This communication is not an offer or solicitation to purchase or sell any security, and it is not a research report. Individuals should consult with a qualified financial professional before making any investment decisions.