While it is of course no guarantee, a number of top economists and strategists are now predicting that the U.S. will begin to see economic growth in the latter part of this year. That begs the question: Which types of stocks perform better coming out of recessions?
In a new research report, Russell Investments examines that issue and finds that, if history is a guide, you can expect small-cap value stocks to lead the way out of the current recession.
According to the report, Russell found that on average, value stocks underperform growth stocks during periods of economic contraction. That trend has reversed “almost immediately” when the economy bottomed out and turned upward, with value significantly outperforming growth in the early periods of economic expansion. That pattern, Russell found, has been strongest among small-cap stocks.
The reason for the pattern is rooted in investor psychology, according to the report: “During periods of market crises and economic uncertainty, investors seek safety and liquidity and avoid riskier markets and assets,” Russell states. “They may see value stocks as being riskier than growth stocks because the valuation metric itself signals that the market sees some kind of trouble: value stocks are usually cheap for a reason.”
Growth stocks, on the other hand, often have unique competitive advantages that “allow their fundamentals to be less sensitive to economic and credit cycles”. Research shows that value companies’ fundamentals, such as earnings and dividend growth, suffer much more than those of growth firms during recessions, Russell states.
The numbers bear this out. Russell studied the four recessions the U.S. has seen since 1980, looking at the 1-year returns an investor would have had if he or she bought into the market 12, 9, 6, and 3 months before the end of the recession; at the very end of the recession; and 3, 6, 9, and 12 months after the recession ended. The firm found that, on average, value began outperforming growth at the 0-month mark (the point at which the recession ended and an economic expansion began.
For the broader market and large-cap stocks, the value premium was greatest, on average, if an investor had bought in three months after the recession ended; for small-caps, value had its greatest outperformance if you bought in three months after the recession ended (value outperformed growth by 16.7 percentage points) or six months after the recession ended (value outperformed growth by 17.4 percentage points). “Even at entry points of +9 and +12 [months], the average 12-month premia — 12.7% and 13.5% — were greater than any experienced in the broad and large cap markets,” Russell states.
Russell does caution that there are exceptions to this growth/value rule. “In 2001, value outperformed growth for all investing entry points until nine months after trough,” the group says. A couple factors could have caused this, according to Russell: “First, growth stocks may have become so expensive due to the tech bubble prior to the 2001 recession that they were actually riskier than value stocks during that recession. Second, the 2001 downturn presented serious dating challenges for the NBER [the group that calls the start and end of recessions], which identified the end of the recession only after a 20-month lag, and controversy continues about the dating of the peak and trough.”
“Nevertheless,” Russell says, “it is important to remember that all recessions are not alike, and that although on average we see a consistent pattern across our sample and for 3 of these 4 recessions, past performance is no guarantee of future investment outcomes.”
In the current recession, value has been trounced by growth. Since that seems to follow the trend highlighted by Russell, I thought it would be good to see which small-cap value stocks my Guru Strategies are currently highest on. The stocks below all get approval from at least two of my models, have market caps between $150 million and $800 million, and have price/book ratios of 1.2 or lower. You may want to keep your eye on these.