Now is the time for these long-ignored stocks


Shep Perkins, Chief Investment Officer, Equities, presents research and insights from Putnam’s equity team on market trends and opportunities.

This month’s author: Michael C. Petro, CFA, Portfolio Manager, Putnam Small Cap Value Fund


Last year, U.S. economic growth rose at its highest rate in 50 years, with the sole exception of 1984. After a dismal 2020 and despite recurring waves of Covid-19, gross domestic product (GDP) roared back to a 5.7% annual growth rate in 2021. This, in our view, is very good news for small-cap value stocks — an asset class investors have ignored for years.

Investors started to pay attention to small-cap value last year, as the promise of strong growth began to trickle down to the more economically sensitive businesses in this investment universe. In 2021, small-cap value stocks outperformed their large-cap value and large- and small-cap growth peers. However, the longer-term numbers tell a different story. For more than a decade through 2020, small-cap stocks, especially small-cap value stocks, underperformed their larger and growth-oriented peers.

Today, we believe conditions are ideal for small-cap value to experience a prolonged period of outperformance. Small caps should benefit as the economy rebounds from the depths of the pandemic and growth broadens beyond select work-from-home technology beneficiaries. A resurging economy combined with higher inflation could bring double-digit nominal growth rates to a wider swath of the investing universe. This should make reasonable growth less scarce and attract investors to the long-neglected small-cap value space.

Inflation can be positive for small-cap value

We are not surprised by the recent surge in inflation. And we believe a reversal of the multidecade disinflationary trend is underway, which is positive for value stocks. The Russell 2000 Value Index has greater exposure to sectors likely to benefit from sustained inflation. These include financials, energy, and basic materials stocks. Just as important, substantially less of this small-cap value index is allocated to sectors that are retreating — notably those that were boosted by the pandemic, such as health care and technology.

Small-cap value has higher weightings in cyclical or rate-sensitive sectors

Index sector weightings as of 12/31/21

Small-cap value has higher weightings in cyclical or rate-sensitive sectors

Sources: Russell 2000 Value Index, Russell 2000 Growth Index, Russell 1000 Index.

Pandemic-induced supply chain problems have been an important contributor to inflation. But aggressive fiscal and monetary responses to the pandemic made an even bigger impact. They are causing an inflationary impulse that is resetting consumer expectations permanently higher. This is reflected in the rising cost of labor. The share of GDP allocated to wages, salaries, and benefits had been in a decades-long downtrend. It now appears to have turned the corner and is on the rise. Cost pressures in this fundamental component of the economy, if sustained, will keep upward pressure on inflation. Also, as businesses cope with overseas supply shortages, many are now optimizing their supply chains on factors other than the lowest price. This is likely to further boost cost-push inflation.

Rising cost of labor could keep upward pressure on inflation

Share of GDP allocated to wages, salaries, and benefits

Rising cost of labor could keep upward pressure on inflation

Source: Federal Reserve Economic Data. Data shown for 9/30/1981–9/30/2021. Blue shaded areas indicate U.S. recessions.

Rising interest rates, too, may drive investors to reconsider value stocks. These are companies whose earnings are typically assessed in the “here-and-now” as opposed to future earnings that will be discounted based on increasingly higher interest rates.

A compelling valuation discrepancy

Investors may also find small-cap value multiples too good to pass up, especially when earnings begin to accelerate for these companies. At the end of 2021, small-cap value stocks were trading at a forward price/earnings ratio of 18.5x. This compares with 50.1x for small-cap growth stocks and 22.5x for the largest 1,000 stocks. (Source: Bloomberg Finance L.P.)

What could spoil our upbeat scenario for small-cap value stocks? Any threat to economic growth would be challenging. This could come in the form of another contagious Covid variant or a breakdown in relations with China that causes a trade war or, worse yet, an outright conflict. Some are concerned the Federal Reserve could raise rates too aggressively and snuff out the recovery. While this is a possibility, we note that real long-term interest rates would still be well below zero.

The competitive edge: Active management

A robust economy, sustainably higher inflation, rising interest rates, and relatively attractive valuations make us bullish on small-cap value. However, our ultimate goal is to build a portfolio that beats our benchmark. To this end, we are focused on finding businesses that can defend their profits during a period of economic growth and inflation — or even better, prosper from it. In 2021, we correctly positioned the portfolio toward deeper value names. But our results were primarily driven by our emphasis on stock selection, particularly in the basic materials and health care sectors. As we navigate the market in this new calendar year, our active management strategy continues, regardless of macroeconomic shifts and challenges.


Explore Putnam Small Cap Value fund

329065




The views and opinions expressed are those of the author, are subject to change with market conditions, and are not meant as investment advice.

Our investment techniques, analyses, and judgments may not produce the outcome we intend. The investments we select for the fund may not perform as well as other securities that we do not select for the fund. We, or the fund's other service providers, may experience disruptions or operating errors that could have a negative effect on the fund. You can lose money by investing in the fund.