The US small-cap sector has performed pretty much according to the historic playbook going into this health emergency driven economic downturn. Investors tend to shun the sector late in economic cycles as they begin to focus on the growing likelihood of a recession and seek to preserve capital in more liquid blue-chip type investments. 
The Russell 2000 index of US smaller companies fell sharply at the beginning of the year as it became clear that GDP was set to turn negative and unemployment surged with the fallout from the global lockdown.
Smaller companies have historically significantly outperformed the S&P 500 index from the midpoint of recessions, and with the gradual lifting of restrictions on business activity now occurring as the virus recedes, the sector looks set to produce some better relative performance.
Chart 1: The timing looks right for a US smaller companies to perform
Source: Bloomberg, William Blair Equity Research January 1980 – February 2020
There are three key reasons why the Russell 2000 Index could appreciate sharply from here.
First, the timing looks right (see chart showing relative performance of Russell 2000 index versus S&P 500 index around recessions). Small caps typically outperform and underperform in cycles of usually around five-to-seven years. Fans of the space have had to endure poor relative gains in small caps since 2014 when the S&P 500 index began pulling away from the pack, as the returns from a select handful of mega-cap technology stocks exploded. So, a new cycle in favour of the small-cap sector could now be due.
The timing is enhanced by the second reason: valuation (see relative price to sales ratio chart). Strategists look at the price to sales ratio of the sector relative to the S&P 500 index. Price to sales is a fair comparison as many smaller companies have not yet achieved profitability. Valuations for small caps are close to record lows.
Finally, the small-cap sector features a great many more companies tied to the fate of the domestic economy, as the scale required to expand overseas has not been reached. Therefore, investors looking for a way to benefit from a coronavirus/economic recovery scenario might want to consider the small-cap sector which benefits nicely from accelerating GDP growth.
Chart 2: US smaller companies on attractive valuations
Source: Bloomberg 31.01.1995 to 24.04.2020
In addition, the post Covid world has created some important new trends with a vast number of smaller growth companies well-positioned to capitalise.
For example, US consumers are more likely to seek out driveable vacations instead of flying. This augurs well for the recreational vehicle or outdoor pursuit sectors, with small-cap boatbuilder Brunswick and all-terrain vehicle manufacturer Polaris Industries nicely positioned. Restaurant stocks are also well represented within the Russell 2000 index and same store sales should see a strong pick up as social distancing requirements are lifted. The publicly listed restaurant chains have better access to capital and should gain new business from private “mom and pop” operators which do not survive the impact of the downturn. Many have already permanently closed.
The crisis has also seen huge demand for telemedicine as patients seek access to medical advice that cannot be obtained visiting medical practices. Teladoc Health, the leading provider of telehealth, has seen a dramatic increase in new subscribers to its service and very impressive share price appreciation.
Elsewhere, the trend for working from home looks set to be permanent. Facebook is planning for half its headquarter based employees to be home-based. We expect to see a complete overhaul of the established US communications infrastructure as the working from home trend gains traction and there are growing demands on network capacity. This should lead to the emergence of a number of category killers in related areas with companies such as Bandwidth in the voice and text communications sector, and Switch in the internet data centre facilities sector looking well-positioned.
Many of the most promising US smaller stocks are recent IPOs and a good way to gauge sentiment for this asset class is to examine the performance of the Renaissance IPO ETF, which provides investors with efficient exposure to a portfolio of newly public companies prior to their inclusion in core US equity portfolios.
Recent IPOs are an important source of ideas for small cap growth investors because companies with unique products or services, early in their evolution, can provide explosive top-line growth. Since the markets bottomed in March this year, the Renaissance IPO ETF has returned 78 per cent compared to 43 per cent for the large-cap S&P 500 index. We suspect this is just the beginning of a longer-term period of outperformance for an asset class which has been out of favour for a long time.
Nick Ford is co-fund manager of the LF Miton US Smaller Companies fund. The views expressed above are his own and should not be taken as investment advice.