Perkins* Portfolio Manager Justin Tugman makes the case for optimism, caution and the potential for the reemergence of quality in US small-cap value equities.

*Perkins Investment Management is a subsidiary of Janus Henderson.

  Key takeaways

• Looking ahead in 2021, we see reasons to be optimistic but also cautious given the swift stock market recovery over the past nine months.
• Our outlook for value is constructive going forward, and we think small cap stocks provide opportunity for investors despite their recent outperformance.
• Quality, which has underperformed thus far, may also prove to be a greater focus as the recovery continues.

 

As we bid good riddance to 2020, it is fair to say nearly everyone is happy this past year is history, but we now need to contemplate what the road ahead will look like for investors. Will it be a smooth journey, or one filled with speed bumps and potholes? It is difficult to imagine a year like we just experienced reoccurring in the foreseeable future, but we also must understand that getting back to “normal” will be a process and not just occur once vaccines are widely available. Equity markets at or near all-time highs belie the fact that significant damage has been done to our economic landscape and the healing process is going to take time.

Looking ahead, we see reasons to be optimistic but also cautious given the swift stock market recovery over the past nine months. We also remain hopeful that value will show improvement going forward and think small-cap stocks provide opportunity for investors despite their recent underperformance. We believe quality, which has underperformed, will be a greater focus than it was this past year.

Reason for optimism in small cap and value

2020 saw unprecedented stimulus campaigns by governments and central banks globally and while we do expect this to slow meaningfully going forward, it won’t be going away. In the US, we saw both fiscal and monetary stimulus programs that showered the markets with liquidity and allowed many low-wage consumers, even those who were temporarily unemployed, to have greater discretionary income than if they had been working at their regular jobs. Undoubtedly, these coordinated efforts helped to boost equity prices around the world. Given that the US federal government will run a deficit of about $3 trillion this year and interest rates have done very little, the will to spend more at the fiscal level will likely continue, giving a further tailwind to the markets. Central banks hungry for inflation for years may finally see their wish granted in 2021.

Earnings growth in 2021 should look strong coming off one of the biggest declines in history. We believe earnings growth is likely to be most pronounced in areas such as small caps, cyclicals and financials, particularly banks, where some of the biggest earnings hits were taken in 2020. In our view, this earnings growth helps the outlook for the previously mentioned market segments, but also value benchmarks, where these groups have significant weights. The lack of earnings growth in value relative to growth benchmarks has been a prime argument for value continuing to lag, but at least for the next year, we see that viewpoint as moot.

Caution is warranted

Although there are many reasons for optimism in the equity markets next year, there are also reasons to be cautious. Given the strong performance of stock prices in 2020, valuations have risen to near all-time highs. This alone doesn’t mean valuations can’t move higher but does indicate that caution is warranted. The US Federal Reserve will continue to be supportive of stocks, but the weak US dollar may begin to become a concern and could limit just how much more the central bank can throw at the economy. Euphoria and unabashed bullishness have been on display in the markets since the March lows, begging the questions: How much of the gains have been pulled forward from 2021 and will this result in more pedestrian returns over the next year?

The reemergence of quality

While the past year was certainly challenging for defensive value-minded investors such as ourselves, we also know that over the long term, seeking to invest in companies that possess strong balance sheets and a positive bottom line will once again become important factors to outperformance. Over the past few years, value and small caps have been underperformers, but with the positives mentioned earlier, we believe the outlook for both groups is attractive going forward.