Peril and Opportunity in Small Value Stocks

The fortune of small value stocks are “irrevocably linked” with today’s key economic questions, according to a recent Morningstar article.

The article argues that this segment of the market is vulnerable: “Even at peak conditions, most small value firms are relatively unprofitable. Nor are they financially robust, recording an average grade of C+ on Morningstar’s Financial Health measure (the market norm being B+).” It adds that these issues might be more manageable but that small value companies typically operate cyclical businesses and usually lack competitive advantage, or wide “moats.”

According to the article, the small value segment has suffered volatile performance swings of late because investors have not been able to “reach a consensus on either the length of the recession or the extent to which old-line industries will recover.”

That said, the article notes, “In uncertainty lies opportunity. Small value issues have sharply lagged other equities, returning 1.5% annualized over the past five years versus the overall market’s gain of 9.8%. Much of that shortfall owes to diminished investor expectations. Should the economic news favor small value companies, with a short recession leading to a conventional recovery, then small value stocks could perform very well indeed, supported by both the economic bounce and higher investor sentiment.”

The article concludes that since we don’t know for sure how long the coronavirus will linger, small value “opportunity is accompanied by peril” and that “those who hold small value stocks should have no illusions about which conditions will help their investments—and which will not.”