Equity Outlook  |  Q1 2019

What’s next for small caps?

William J. Monroe, CFA, Portfolio Manager of Putnam Small Cap Growth Fund

What’s next for small caps?

Small-cap growth stocks took quite a hit in the fourth-quarter downturn, and investors may wonder if there is any good news for the asset class as we begin 2019. The Russell 2000 Growth Index — which had advanced by 15.7% by the close of September — plummeted 21.6% in the final quarter of 2018.

Small-cap stocks are still somewhat expensive by traditional price-earnings measures, but we believe there are many opportunities in the wake of the steep decline. Also, some of the basic characteristics of these stocks provide an advantage in the current economic environment.

Small-cap companies are often more domestically focused than large-cap companies. Therefore, they may have less exposure to international markets, which have experienced some of the sharpest recent slowdowns in economic activity. Also, these U.S.-focused companies continue to benefit from new, lower corporate tax rates. Finally, small domestic companies tend to be less exposed to the U.S.–China trade conflict and other geopolitical issues.

The technology sector offers attractive opportunities for growing small companies. The newer business model known as SaaS — software as a service — has enabled small businesses to compete with the larger, entrenched technology providers. We’re invested in many small companies that have more advantaged technology than the old incumbents. Moreover, the recurring-revenue nature of their businesses models makes them much higher quality than a typical younger company. Despite the downturn, these companies remain in high-growth mode, and we believe they will continue to take market share of large-enterprise spending.

One example of a SaaS company in our portfolio is Everbridge. This company offers services to help businesses with critical event management. For example, it provides incident response technology, preparedness training, and alert systems for communicating during emergencies in real time with employees and community residents.

Macroeconomic conditions have been a consideration in some of our allocation decisions. For example, we slightly reduced our portfolio’s exposure to the industrials sector. We may be entering a period of disrupted trade, in which small U.S. companies may have more difficulty landing contracts with large international businesses. Also, we are more cautious about industrial or materials companies with exposure to emerging markets.

The newer business model known as SaaS — software as a service — has enabled small businesses to compete with the larger, entrenched technology providers.

We also see advantages for small companies in the consumer discretionary sector. For example, almost all large-cap retailers have been struggling with the “Amazon effect” — the competitive threat from online retailers. In the small-cap space, we have identified a number of businesses that offer unique, niche products and services that are not typically offered by online retailers and may ward off the threat of competition.

One example in our portfolio is Five Below, a chain of roughly 650 stores that sells a range of products, all priced under $5. The company’s merchandise is targeted to young teens and includes items that make the most sense as in-store purchases. Five Below delivered strong earnings growth in 2018, and we believe it can continue. The company’s aggressive expansion strategy includes plans to triple its store count.

With the increase in interest rates, we have reduced positions in companies that have balance sheet leverage. We do not believe they would have issues in terms of paying their debt, but they might be limited in their ability to grow through M&A in a rising-rate environment.

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