Morningstar - Q2 2024 - 15

EXHIBIT 1
Waiting for Small Caps
AMERICAS
United States
Now could be a good time to consider US small
caps. Contrary to a broad academic consensus that
small-cap stocks tend to outperform large caps,
small caps have trailed for an extended period,
which suggests they could rebound. Valuations are
compelling, too. In terms of price/earnings,
small-cap valuations are low relative to their own
history and large caps (EXHIBIT 1 ). Morningstar
equity analysts' stock-by-stock reviews of small caps'
price/fair value estimates also suggest they're
cheaper than large caps. Finally, small caps are a
fruitful hunting ground for active managers, who
should benefit by avoiding a rising number of
low-quality companies in the small-cap universe.
To test the effect of quality on performance,
we bucketed active funds' holdings and stocks in
the Russell 2000 Index into quintiles based on
quality, which we defined as an equally weighted
mix of trailing 12-month return on equity and debt/
capital ratios. We found that index performance
closely followed quality. In the 15 years through
2023, the highest-quality quintile beat the
lower-quality ones. Although there were brief
periods when low quality outperformed, most
recently in the 2020-21 rally after covid vaccines
were released, we learned that it pays to avoid
low-quality businesses over the long term.
However, when we ran the same analysis for
active small-cap funds' holdings, performance
did not correlate as neatly with quality levels as it
did with the Russell 2000 Index. For example,
bucket 4 (the second lowest in quality) posted the
best results over the same 15-year period,
while bucket 1 (the highest quality) finished last.
Additionally, the spread between first and fifth
quintiles' returns was more compressed than that
of the index. This was likely due to active
managers' limited exposure to the index's highest
quality-and highest-returning-bucket 1 stocks.
So why didn't active managers simply load up on
high-quality stocks? Quality, it turns out, is a
20
Small Caps Have Traded at a Big Discount in Recent Years
30
Morningstar US
Large-Mid Cap Index
23.40
Large-Cap Long-Term Avg
19.20
Small-Cap Long-Term Avg
17.20
10
12/2008
12/2013
Source: Morningstar Direct. Data as of Dec. 31, 2023.
12/2018
12/2023
Morningstar US
Small Extended Index
15.17
EXHIBIT 2
Maintaining a High-Quality Small-Cap Portfolio Requires Active Sector Shifts
20
10
-10
-20
03/2009
03/2013
03/2018
Source: Morningstar Direct. Data as of Dec. 31, 2023. Data relative to the iShares Russell 2000 ETF.
12/2023
o Energy
8.08
a Technology
6.55
y Financial Services
-7.38
d Healthcare
-7.57
moving target, making it difficult for active
managers to consistently invest in a portfolio
of the highest-quality stocks. In fact, managers
seeking to do this needed to be adept in
their portfolio positioning and make big, potentially
career-risking sector bets. EXHIBIT 2 shows
the largest active underweights or overweights-
and rapid shifts between them-required to
maintain exposure to the highest-quality stocks.
Another reason managers struggle to own quality
is that index composition could also push
them into lower-quality areas of the market. One
such example is biotech, which in the small-cap
universe often consists of nascent businesses
with little to no earnings. They can often be highly
indebted and reliant on the commercial success
of a single drug, so they struggle with our
definition of quality. That said, the industry is hard
to ignore-particularly for growth managers,
given its prominence in the Morningstar US Small
Growth Index, where it peaked near 12% in
mid-2021 before falling to roughly 9% by year-end
2023. The median growth manager owned a
lot, though remained slightly underweight versus
the index. Despite having its moments, biotech
was a net drag on the Morningstar US Small Cap
Healthcare Target Market Exposure Index in
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15
Active Weight %
Price/Earnings Ratio (Trailing 12 Months)

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Morningstar - Q2 2024

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