US small cap growth: A big opportunity for long-term investors

• Inflation resistance: In the inflationary 1970s, US small caps outperformed large caps by 4% annually.
• Compelling value: US small caps are trading at a 42.6% price-to-earnings discount to large caps—well below the historical average.
• Favorable growth outlook: Short-term earnings growth expectations for US small caps are about three times higher than for large caps.

From World War II until now, the US has experienced roughly half a dozen episodes in which inflation (as measured by the Consumer Price Index) exceeded 5%. The 1970s isn’t the most recent occurrence of heightened inflation, but the decade does represent the longest stretch of it. For insight into that era, we turn to the work of well-known economist Ken French, which relies on data from the Center for Research in Security Prices (the Russell 2000 Index didn’t exist until 1984). From 1970 through the end of 1979 — when inflation surged from nearly 6% to almost 14% — US small cap stocks returned 9.0% per year, compared with 5.4% for US large caps (Exhibit 1). While this doesn’t necessarily show a correlation between high inflation and small cap outperformance, it does suggest that rising costs present different obstacles to large companies than to their smaller peers — and that some small companies should be better positioned to overcome price inflation.

Small cap companies (those with a market capitalization under $2 billion) tend to have lower margins and may get squeezed by inflated input costs. However, well-managed small companies may be able to pass along price increases to their customers while controlling their own costs and increasing their productivity. We believe that these companies should enjoy stronger earnings growth, since incremental improvements in operating margins will have a more pronounced effect relative to their larger, higher-margin counterparts.

Following sharp compression in earnings multiples year to date, US small cap growth stocks are at their cheapest levels relative to large cap growth stocks since June 2003. Over the long term, the Russell 2000 Growth Index (R2000G) has traded at a 4% average price-to-earnings (P/E) discount to the Russell 1000 Growth Index (R1000G). Today, the P/E ratios for the indexes are 14.12x and 24.58x, respectively, representing a 42.6% discount (Exhibit 2).

Beyond the P/E story, US small caps are trading at discounts to their large cap counterparts across most valuation metrics, except for price to sales (Exhibit 3). Since valuation relationships tend to revert to their means, we see potential for significant relative upside for the small cap universe.

Amid market expectations for slowing short-term earnings growth through 2023, we believe US small cap stocks have an edge over US large caps. The R2000G Index is expected to grow earnings by 11.0% over the next 12 months, compared with 8.3% for the R1000G Index and 3.7% for the S&P 500 (Exhibit 4). To navigate this environment, we are targeting companies and industries that we believe should benefit from strong secular demand trends, such as IT software companies that offer security, accounting or efficiency-enhancing services. In our view, companies with a decisive competitive edge (due to proprietary technology or high barriers to entry) should outperform their respective markets.

Voya’s approach to US small cap growth investing favors companies with the following attributes:

• Strong cash flow–generation capabilities and a minimum of 15% revenue and earnings growth
• High earnings quality — paying special attention to trends in operating cash flow versus adjusted net income, recognizing that the former is the “life blood” of a company looking to reinvest in growth
• Sustainable valuations compared with their competitors as well as to the company’s own historical valuation range

This approach has historically helped the Voya Small Cap Growth Fund mitigate losses when markets fall (i.e., a lower “down-market capture”), while allowing it to participate in the upside when markets are performing well (i.e., a higher “up-market capture”) (Exhibit 5).

As investors continue to grapple with questions about inflation, geopolitical concerns and economic difficulties, we believe US small cap stocks offer attractive characteristics for those pursuing long-term investment goals.