This Market Insight has been updated with new data since it was originally published on 3/2/21.
Higher quality small-cap companies lagged their lower quality peers through February, extending a trend that began in November. Investors, encouraged by the promise of COVID-19 vaccines and additional fiscal stimulus, piled into lower quality small-cap stocks that were hit hard early in the pandemic, boosting performance.
The dispersion between high and low quality exists across the market cap spectrum but is most apparent in the small-cap space. As shown in the chart below, in both Q4 and year to date through February, small-cap companies with lower quality metrics — S&P Stock Rankings of B or below, high betas (2.0 or higher), below-investment grade credit quality, and a negative return on equity (ROE) — outperformed small-cap companies with higher quality metrics — S&P Stock Rankings of B+ or better, low betas (under 1.0), investment grade credit quality (BBB and above), and ROE of 20% or higher.
HIGH QUALITY VS. LOW QUALITY PERFORMANCE — RUSSELL 2000® INDEX
Sources: KAR and FactSet. Data as of 2/28/2021. Past performance is not indicative of future results. S&P quality rankings, betas, credit quality, and ROE of stocks in the Russell 2000® Index for periods cited. See disclosure section below for index and investment term definitions.
HIGHER QUALITY SMALL-CAP STOCKS HAVE OUTPERFORMED OVER TIME Periods of high quality underperformance are normal over market cycles. Although tailwinds have clearly favored lower quality small-cap stocks in recent months, it’s important to maintain a long-term perspective. As shown below, higher quality small-cap stocks have delivered better risk-adjusted returns over the last 30 years.
S&P quality rankings of stocks in the Russell 2000® Index, 4/1990-12/2020. Source: FactSet. Past performance is not indicative of future results.
Russell 2000® Index: A market capitalization-weighted index of the 2,000 smallest companies in the Russell Universe, which comprises the 3,000 largest U.S. companies. S&P Quality Rankings: Stocks with an S&P Quality Ranking of B+ and above are defined as High Quality. Stocks with an S&P Quality Ranking of B and below are defined as Low Quality. Return on Equity (ROE): The amount of net income returned as a percentage of shareholders’ equity. ROE measures a corporation’s profitability by revealing how much profit a company generates with the money shareholders have invested. Beta: A quantitative measure of the volatility of a given stock relative to the overall stock market. Higher beta suggests higher volatility. Credit Quality: BBB and above are considered investment grade bonds. BB+ and below are considered below-investment grade bonds.
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