Behind the small-cap surge

Small-cap stocks may have benefited from an accelerating economy and hopes for policy changes.

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Small-cap stocks had a banner year in 2016. The Russell 2000 gained 21%, including a nearly 9% jump in the fourth quarter, far outpacing the large-cap S&P 500 gains of 12% for the year and 3.8% in the fourth quarter.

Viewpoints caught up with Patrick Venanzi, manager of Fidelity’s Small Cap Growth Fund (FCPGX), to ask him why small-company stocks shone last year and to hear his outlook for the next six to 12 months. He says that while investors in certain parts of the small-cap market may be overly excited about the potential impact of lower taxes, less regulation, and infrastructure spending, he’s finding opportunities in tech, financial companies, and other companies that he believes can grow earnings no matter what happens with government policy.

Q: Why did small caps perform so well in 2016?

Venanzi: The U.S. presidential election helped accelerate a rally that was already happening, particularly in the cyclical sectors of the market. But the story began before that.

Over the past 35 years, small-cap valuations have averaged a 3% premium to large caps. Around 2013, the premium had gotten up to 20%. That started to shift in 2014; large-caps began to outperform, and by the beginning of 2016, small-caps traded at a discount to large-caps. That was an attractive setup.

Then last year, the economic environment started to look better for small-caps. Small-cap stocks historically tend to do better when gross domestic product (GDP) is accelerating and interest rates are rising. That’s partly because small-caps tend to be more domestically focused than large-caps, and as the U.S. GDP picks up, the companies that have more direct exposure to it tend to do better. Economic growth improved in each of the first three quarters of the year. In addition, lower taxes and higher government spending, if they are realized in the new administration, could build on that momentum. The U.S. Federal Reserve raised rates in December, in part because of the potential for faster economic growth in 2017.

Within the small-cap market in 2016, value outperformed growth. The Russell 2000 Value Index gained 31% on the year, compared to 11% for the Russell 2000 Growth Index. The value indexes have more exposure to cyclical sectors such as energy, financials, materials, and industrials. They led growth sectors such as technology and healthcare throughout the year, and the gap grew after the election.

Q: What’s your take on small caps following this rally?

Venanzi: There is a lot of uncertainty right now. Since the election, expectations of infrastructure spending and tax reform have helped drive certain parts of the market much higher. However, some of the potential upside from these factors is already priced in at this point, and I’m somewhat cautious. I think there are just too many ways to lose when you’re making portfolio decisions based solely on expectations for changes in government, monetary, or regulatory policies. Say you buy a stock because you think a big infrastructure bill is coming, but the bill is passed later than you think or is smaller than you expect—what is the underlying business that are you left with? That’s one reason I generally focus on companies that aren’t too dependent on policy changes or regulatory reforms, and can generate relatively stable growth regardless of the economic or policy environment.

What’s more, lower corporate taxes might not add as much to profits as some investors seem to think. For many companies, the benefits of lower taxes will, over time, be competed away. For example, some companies might just pass the tax savings on to customers in the form of lower prices. For companies that do this, profit margins might eventually end up right where they started. That’s less of a risk for companies selling a more differentiated product, because these companies are likely to keep more of any additional profits that result from tax reform.

Also, a lot of small-cap tech and health care companies don’t make money yet, so they’re not going to save much on income taxes because they don’t have a lot of profits to tax. And if the border tax that’s under discussion winds up happening, companies like retailers that do a lot of importing will be hurt. In that case, the direct beneficiaries would be companies that don’t import much. U.S.-focused restaurants could stand to benefit from higher disposable income if personal income-tax rates go down.

Merger-and-acquisition activity also is important for small-caps. M&A has been running at an elevated level for the past four or five years. Even so, there’s still a lot of private equity money on the sidelines waiting to be invested, so I wouldn’t be surprised to see M&A continue at this level. That’s likely to be good news for small-caps. Large companies looking to generate growth often try to get it by buying small firms, often at premium prices, which benefits the smaller companies’ shareholders.

Q: Where are you finding opportunities among small caps?

Venanzi: My general approach is to favor companies with sustainable competitive advantages and multi-year growth stories that look appealing regardless of the macro environment. I think this is an especially good time for that kind of approach, given the uncertainty about what’s going to happen in terms of policy and the economy.

I think in some cases stocks that have been viewed as beneficiaries of the election have gotten ahead of their fundamentals. That’s one reason I have been looking for opportunities beyond the obvious beneficiaries of the “Trump rally.” For example, technology has lagged since the election, but there are some good secular growth stories there. Software-as-a-Service companies (SaaS)—those with subscription-based models—have very attractive five- to 10-year growth trajectories, as they benefit from the transition from the traditional licensed model to the subscription-based model.

I’m also paying attention to some opportunities that are more in line with the market consensus, such as certain defense stocks. Naval spending is likely to grow, so companies with exposure there may benefit.

Parts of the education industry also look promising. Certain education stocks look interesting on their merits, and could benefit if the new administration treats the for-profit education sector more favorably than the prior administration did, which seems likely.

Financial stocks have done well since the election, due to the expectation that they’ll benefit from rising rates, less regulation, and faster economic growth. Some of that good news may have been priced in already, but certain stocks still look attractive. Meridian Bancorp is a bank that the fund held prior to the election, and continued to hold. A more-relaxed regulatory environment could also give a boost to M&A activity in the financial sector.

Another notable occurrence since the election is a surge in consumer and business confidence. If improved confidence is sustained, that would be good for many small-cap consumer discretionary companies, and perhaps for the market overall.

Q: Do certain parts of the small-cap market look overvalued to you?

Venanzi: Many industrial stocks saw prices go practically straight up after the election. That seems like one area where some small-cap stocks may have priced in benefits a bit too quickly. There are still a lot of details to be worked out about any forthcoming infrastructure spending, and any related earnings benefit might not show up until 2018. I’d contrast that with some financials, where the post-election surge might be more justified. Financial stocks are up partly on expectations for policy changes, such as lower regulation and taxes, but also on things that have actually happened—rates are already up, and that should benefit financial companies’ profits.

I’ve been underweight retail for a long time, largely because of the shift to online consumption. There’s simply not that much secular growth with small-cap retailers. The fund is also underweight health care, largely due to underweighting in biotech. Most small-cap biotech companies don’t make money yet, and I generally tread lightly in this loss-making part of the small-cap universe. Health care has underperformed of late, in part due to policy uncertainty. As the new administration’s health care policy details emerge, some good opportunities may arise in this sector.

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Before investing, consider the funds’ investment objectives, risks, charges, and expenses. Contact Fidelity for a prospectus or, if available, a summary prospectus containing this information. Read it carefully.
The information presented above reflects the opinions of the speaker, as of January 23, 2017. These opinions do not necessarily represent the views of Fidelity or any other person in the Fidelity organization, and are subject to change at any time based on market or other conditions. Fidelity disclaims any responsibility to update such views. These views may not be relied on as investment advice and, because investment decisions for a Fidelity fund are based on numerous factors, may not be relied on as an indication of trading intent on behalf of any Fidelity fund.
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Pat Venanzi manages Fidelity Small Cap Growth Fund, which invests in some of the securities mentioned in this article. As of Oct. 31, 2016, the fund held 1.032% of assets in Meridian Bancorp, Inc.

Past performance is no guarantee of future results.

Stock markets are volatile and can decline significantly in response to adverse issuer, political, regulatory, market, or economic developments.
Value stocks can perform differently from other types of stocks and can continue to be undervalued by the market for long periods of time.
Investments in smaller companies may involve greater risks than those in larger, more well-known companies.
Russell 3000 is a stock index that tracks the 3,000 U.S. stocks with the highest market capitalization. The list is updated yearly, during a process known as reconstitution. There are two sub indexes that are based on the Russell 3000: the Russell 1000, which follows the 1,000 stocks with the largest market capitalization values, and the Russell 2000, which follows the remaining 2,000 stocks, those with the smallest values.
For the Russell Value and Growth indexes, stocks are ranked by their book-to-price ratio (B/P), their I/B/E/S forecast medium-term growth (2 year) and sales per share historical growth (5 year). These rankings are converted to standardized units, where the value variable represents 50% of the score and the two growth variables represent the remaining 50%. They are then combined to produce a composite value score (CVS). Stocks are then ranked by their CVS, and a probability algorithm is applied to the CVS distribution to assign growth and value weights to each stock. In general, a stock with a lower CVS is considered growth, a stock with a higher CVS is considered value and a stock with a CVS in the middle range is considered to have both growth and value characteristics, and is weighted proportionately in the growth and value index. Stocks are always fully represented by the combination of their growth and value weights; e.g., a stock that is given a 20% weight in a Russell value index will have an 80% weight in the corresponding Russell growth index.
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