Optimism for a Renewed Focus on Fundamentals in Small- and Mid-Cap Growth
As we look ahead to 2021, we have reasons for optimism, both for the economy and for disciplined growth investing. We have been encouraged by positive clinical trial results for several COVID‑19 vaccines and therapies, and we expect multiple vaccines to obtain broad FDA approval within the next several months. While it will take time for a vaccine to be widely distributed, we believe the market will react favorably to this milestone as the first step toward a return to normalcy. Additionally, the U.S. Federal Reserve has signaled that it will likely keep interest rates at or near zero for the foreseeable future, and this could provide further support for the economy and asset prices.
Return to Normalcy May Lead to a Renewed Focus on Stock Fundamentals
One of the most noteworthy market trends of 2020 has been the disconnect between stock performance and company fundamentals in the small- and mid-cap markets. Among small caps, we have seen the stocks of money-losing companies outperform those of money makers by a ratio of two to one. We saw a similar dynamic in the mid-cap market, where a few very expensive companies have driven most of the market gains this year. Several factors contributed to this disconnect, including historically low interest rates. Investors also sought opportunities in companies with virtual business models that they believed might benefit from the pandemic — even when these companies were not yet profitable. At the same time, investors avoided stocks they believed might be susceptible to near-term earnings impacts because of COVID-19 without considering their long-term growth potential. Lastly, the resurgence of individual investors “day trading” on low-cost investment platforms such as Robinhood exacerbated momentum-driven, rather than fundamentals-driven, moves in certain areas of the equity markets.
We have argued such a disconnect is unsustainable. In the third quarter we saw signs this dynamic may be shifting, as profitable, moderately valued companies performed better on a relative basis even if they still lagged the broader market. In our view, this improved performance reflected a renewed focus on fundamentals as investors’ attention periodically shifted away from the pandemic.