Small caps, after the crisis

No one likes a bear market. But unless we believe the bear is here to stay, there’s probably a clearing at the far side of this volatile period of investing history. As we’ve seen in the past, actions taken during a major market decline can have significant implications for absolute and relative returns moving forward.

If for nothing else, the recent sell-off will be remembered for the speed of its onset and its jaw-dropping depth. From a high on February 20 through March 23—the bottom of the market’s drawdown to date—the Russell 2000 Index fell 41%, and the S&P 500 Index dropped by 34% over the same timeframe.

Looking back over the last 40 years, there’s a short list of periods in which both indexes decreased by 30% or more. What appears to be a relative constant, though, is that small caps tend to fall a bit further than large caps in bear markets. And notably, small caps have also rebounded significantly higher off the bottom.

Small-cap performance during major drawdowns, and after. The table compares returns for large and small caps during crisis periods over the last 40 years in which both representative indexes (R2000 and S&P 500) declined by more than 30%. Off the eventual bottom in all cases, the forward one-year price change for small-cap stocks was greater than that of large-cap stocks.

Investors have repeatedly shown that they prefer small caps when uncertainty recedes and risk appetites return. If we can assume that markets will function at anything approaching normal levels in future quarters, then we believe the time for pursuing high-quality small-cap opportunities is now.

In the short term: depressing news for the economy

Over the next few months, the outlook for the U.S. economy is not good. As much of the developed world continues on hiatus in response to the spread of COVID-19, we know that top-line revenues for most companies will be extremely weak.

On top of this, corporate debt remains high. According to the U.S. Federal Reserve, there’s US$10.1 trillion of U.S. nonfinancial corporate debt outstanding, which is actually up from US$8.4 trillion three years ago. In this environment, it’s not hard to see the dominoes fall for companies across the capitalization spectrum, but particularly overlevered small caps.

Valuations will continue to beckon

As an investor, it’s impossible to ignore how the volatility has affected most things equally, without regard to fundamentals. During the early weeks of the drawdown, just about everything declined in lockstep because investors who either needed to raise cash or panicked sold what they could.

But this doesn’t mean that the basic building blocks of a normative recovery are gone: Small-cap valuations, for one thing, are extremely attractive. Investors typically require a higher risk premium for small caps. But the FAANG influence, combined with the recent sell-off, has made small caps especially cheap. In fact, the relative relationship is approaching one standard deviation for P/E and is well beyond that level when we consider the ratio of enterprise value to EBITDA for small caps ex biopharmaceuticals. That’s an extraordinary level of valuation change that’s happened only a handful of times in the last 20 years.

Now is a time to hunt for tomorrow’s earnings surprise

Fundamentals will continue to matter, of course, as will a general ability to adopt a more defensive posture. It’s made sense to us, for example, to reduce exposure to the energy sector, where the price of oil has collapsed; to trim those technology holdings whose supply chains are vulnerable to pervasive trade interruptions; and to limit exposure to those consumer companies whose operations have all but ceased as a result of public lockdowns.

And yet, in a sense, opportunities abound. High-quality, underlevered small caps with ironclad balance sheets continue to operate, including companies in consumer staples, technology, and healthcare. Mobile gaming companies are benefiting from household “nesting,” and there’s no shortage of small tech companies that should benefit from increased levels of working from home. These companies are the technology infrastructure wizards that are enabling widespread and rapid corporate transformation along a brand-new path to digital work, helping businesses solve problems around communication and secure and effective collaboration. In a variety of cases, we see emerging catalysts that could arguably propel strong earnings growth through the other side of today’s crisis.

I’ll close by stating the obvious: No one knows where or when we’ll arrive at the bottom of today’s dislocation, and it would be foolish not to expect more risk-off days ahead. But as active investors, we do see evidence of life among high-quality small caps—names that dominate their niche and have a history of disciplined free cash flow generation with a limited reliance on leverage. We would expect that as investors return to making distinctions among companies, high-quality names with durable long-term demand will rise to the top.

A widespread health crisis such as a global pandemic could cause substantial market volatility, exchange trading suspensions and closures, and affect portfolio performance. For example, the novel coronavirus disease (COVID-19) has resulted in significant disruptions to global business activity. The impact of a health crisis and other epidemics and pandemics that may arise in the future, could affect the global economy in ways that cannot necessarily be foreseen at the present time. A health crisis may exacerbate other pre-existing political, social and economic risks. Any such impact could adversely affect the portfolio’s performance, resulting in losses to your investment.

Investing involves risks, including the potential loss of principal. Financial markets are volatile and can fluctuate significantly in response to company, industry, political, regulatory, market, or economic developments.  These risks are magnified for investments made in emerging markets. Currency risk is the risk that fluctuations in exchange rates may adversely affect the value of a portfolio’s investments.

The information provided does not take into account the suitability, investment objectives, financial situation, or particular needs of any specific person. You should consider the suitability of any type of investment for your circumstances and, if necessary, seek professional advice.

This material, intended for the exclusive use by the recipients who are allowable to receive this document under the applicable laws and regulations of the relevant jurisdictions, was produced by, and the opinions expressed are those of, Manulife Investment Management as of the date of this publication, and are subject to change based on market and other conditions. The information and/or analysis contained in this material have been compiled or arrived at from sources believed to be reliable, but Manulife Investment Management does not make any representation as to their accuracy, correctness, usefulness, or completeness and does not accept liability for any loss arising from the use of the information and/or analysis contained. The information in this material may contain projections or other forward-looking statements regarding future events, targets, management discipline, or other expectations, and is only as current as of the date indicated. The information in this document, including statements concerning financial market trends, are based on current market conditions, which will fluctuate and may be superseded by subsequent market events or for other reasons. Manulife Investment Management disclaims any responsibility to update such information.

Neither Manulife Investment Management or its affiliates, nor any of their directors, officers or employees shall assume any liability or responsibility for any direct or indirect loss or damage or any other consequence of any person acting or not acting in reliance on the information contained herein.  All overviews and commentary are intended to be general in nature and for current interest. While helpful, these overviews are no substitute for professional tax, investment or legal advice. Clients should seek professional advice for their particular situation. Neither Manulife, Manulife Investment Management, nor any of their affiliates or representatives is providing tax, investment or legal advice. Past performance does not guarantee future results. This material was prepared solely for informational purposes, does not constitute a recommendation, professional advice, an offer or an invitation by or on behalf of Manulife Investment Management to any person to buy or sell any security or adopt any investment strategy, and is no indication of trading intent in any fund or account managed by Manulife Investment Management. No investment strategy or risk management technique can guarantee returns or eliminate risk in any market environment. Diversification or asset allocation does not guarantee a profit nor protect against loss in any market. Unless otherwise specified, all data is sourced from Manulife Investment Management.

Manulife Investment Management

Manulife Investment Management is the global wealth and asset management segment of Manulife Financial Corporation. We draw on more than 150 years of financial stewardship to partner with clients across our institutional, retail, and retirement businesses globally. Our specialist approach to money management includes the highly differentiated strategies of our fixed-income, specialized equity, multi-asset solutions, and private markets teams—along with access to specialized, unaffiliated asset managers from around the world through our multimanager model.

These materials have not been reviewed by, are not registered with any securities or other regulatory authority, and may, where appropriate, be distributed by the following Manulife entities in their respective jurisdictions. Additional information about Manulife Investment Management may be found at

Australia: Hancock Natural Resource Group Australasia Pty Limited., Manulife Investment Management (Hong Kong) Limited. Brazil: Hancock Asset Management Brasil Ltda. Canada: Manulife Investment Management Limited, Manulife Investment Management Distributors Inc., Manulife Investment Management (North America) Limited, Manulife Investment Management Private Markets (Canada) Corp. China: Manulife Overseas Investment Fund Management (Shanghai) Limited Company. European Economic Area and United Kingdom: Manulife Investment Management (Europe) Ltd. which is authorised and regulated by the Financial Conduct Authority, Manulife Investment Management (Ireland) Ltd. which is authorised and regulated by the Central Bank of Ireland Hong Kong: Manulife Investment Management (Hong Kong) Limited. Indonesia: PT Manulife Aset Manajemen Indonesia. Japan: Manulife Asset Investment Management (Japan) Limited. Malaysia: Manulife Investment Management (M) Berhad (formerly known as Manulife Asset Management Services Berhad) 200801033087 (834424-U) Philippines: Manulife Asset Management and Trust Corporation. Singapore: Manulife Investment Management (Singapore) Pte. Ltd. (Company Registration No. 200709952G) South Korea: Manulife Investment Management (Hong Kong) Limited. Switzerland: Manulife IM (Switzerland) LLC. Taiwan: Manulife Investment Management (Taiwan) Co. Ltd. Thailand: Manulife Asset Management (Thailand) Company Limited. United States: John Hancock Investment Management LLC, Manulife Investment Management (US) LLC, Manulife Investment Management Private Markets (US) LLC and Hancock Natural Resource Group, Inc. Vietnam: Manulife Investment Fund Management (Vietnam) Company Limited.

Manulife Investment Management, the Stylized M Design, and Manulife Investment Management & Stylized M Design are trademarks of The Manufacturers Life Insurance Company and are used by it, and by its affiliates under license.


Bill J. Talbot, CFA

Bill J. Talbot, CFA, 

Senior Portfolio Manager, Head of U.S. Small-Cap Equities

Manulife Investment Management

Read bio