A Value Investor’s View on US Small-Cap Stocks

Franklin Small Cap Value Fund Portfolio Manager Steve Raineri gives five reasons why he thinks small-capitalization (small-cap) value stocks could perform well as the US economy continues to recover from the COVID-19 pandemic.

During a broad COVID-19 equity market selloff in March and April, US small-cap stocks were hit particularly hard.1 At the time, investors seemed especially concerned about how these companies would fare in a US economic slowdown.

Since then, many small-cap stocks, as represented by the Russell 2000 Index, have rallied from April’s lows as the US government and Federal Reserve’s rapid response to the COVID-19 crisis helped lift markets. Given the index’s most recent performance, some investors have asked us for our views on a potential sustained rally in small-cap stocks.

Here, we outline five reasons we think small-cap stocks, particularly those with select value characteristics, are worth considering at this time.

Reason #1: Compelling Valuations

As the chart below shows, at the end of August 2020, small-cap value stocks in the Russell 2000 Value Index were trading near their lowest levels in 10 years, compared to the large-cap value stocks in the Russell 1000 Value Index, as measured by price-to-earnings (P/E) ratios.2

We see a few reasons for this difference in valuations, including the belief mentioned above that all small-cap stocks are more susceptible to a US economic downturn. While that’s true for many stocks in the Russell 2000 Value Index, it’s not true for all of them, particularly select small-cap value stocks with higher margins, lower leverage and decent earnings growth.3