2020 Outlook: US Small Cap

Timely insights from portfolio managers and industry experts on key financial, economic and political issues.

The views expressed in these posts are those of the authors and are current only through the date stated. These views are subject to change at any time based upon market or other conditions, and Eaton Vance disclaims any responsibility to update such views. These views may not be relied upon as investment advice and, because investment decisions for Eaton Vance are based on many factors, may not be relied upon as an indication of trading intent on behalf of any Eaton Vance strategy. The discussion herein is general in nature and is provided for informational purposes only. There is no guarantee as to its accuracy or completeness.

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      By J. Griffith Noble, CFACo-Director of US Small Cap Equity, Eaton Vance Management

      Boston - In 2019, we saw significant multiple expansion in small caps. Now in 2020, we really need to see strong earnings growth.


      Valuations are fairly stretched, with small cap stocks looking cheap relative to large cap stocks, but expensive on an absolute basis. So we think investing in US small caps in 2020 will be all about finding good companies with strong fundamentals and earnings growth.

      Economic expansion to support earnings growth...

      There are some reasons to think earnings could grow if the economy continues to expand. The US consumer is still strong, and consumer balance sheets remain robust. The US Federal Reserve (Fed) and global central banks have the back of the markets. If these conditions continue, it's reasonable to think earnings could be up materially for small cap stocks.

      ... Or a challenging macro backdrop?

      On the other hand, there are reasons to believe that the macro backdrop could be more challenging. We're 11 years into an expansion, at full employment, so it's hard to see where potential growth could come from after that. And we've seen some issues on spreads in the riskier parts of the credit markets. Maybe the earnings backdrop could also be more challenging for small cap stocks. If there were to be a weaker macro backdrop or even a recession, it's likely to expect that small caps would underperform large caps.

      Positioning for high quality

      When you get late in the cycle and potentially in a downturn, we think it makes sense to be positioned and have exposure to high quality stocks. That's why our investment process focuses on businesses with a higher return on capital and less leverage. We've found that high return on capital has demonstrated significant excess return over the cycle — and especially in more challenged environments. And relative to low return on capital stocks, high return on capital companies, as measured by return on equity (ROE), actually look pretty cheap to us.

      Bottom line: Not only has a focus on quality in US small caps helped to generate better performance during downturns and more challenging environments, but it also appears that high quality may be cheap relative to low quality in small cap markets.