A recent article in Verdad Research defends small-cap value investing by arguing that “though the past few years have been painful for small-value investors, this is perhaps a once-in-a-century buying opportunity in this deeply out-of-favor asset class.”
The article notes that two statistical predictors for future small-cap returns—high yield spread and growth/value price ratios—are at “some of their highest readings ever on record” which represents “an extremely rare ‘double eclipse’ for market historians.”
High yield spreads
This indicator measures the spread between the borrowing rate for below-investment-grade bonds and the corresponding ‘safe’ interest rate. When the high-yield spread rises, it reflects higher borrowing costs for smaller, less-creditworthy businesses, the article explains. It also represents a “gauge for monitoring market sentiment for small and micro-cap companies because it combines real-world economic consequences and the temperature of the market.”
The article notes that last quarter “saw high-yield spreads jump 520 bps to 880 bps, a level last seen in September 2009,” noting that when high-yield spreads spike, “investors tend to flee from small value equities, scared that these companies will be unable to refinance their debt and that the risk of bankruptcy is significantly higher than anticipated.”
Growth/Value Ratio
The underperformance of value has led to widening spreads between growth and value, the article argues, adding that the ratio went from “moderately high at the end of 2015 to nearly three standard deviations above the long-term median today.” It cites data showing that from the end of 1999 to 2006, the “smallest, cheapest decile of stocks returned a total return of 530% while the S&P 500 returned 8%,” noting that, “We are now at the 97th percentile of the historical data.”
The article concludes that these indicators underscore the painful journey for small-value investors in recent years, but suggests that “when the recovery begins and the market turns (and maybe it already has), small-cap value is uniquely positioned to capitalize on perhaps a once- or twice-in-a-century convergence of opportunities.”
