The small-cap index changes, but our process stays the same

Shep Perkins, CFA

Chief Investment Officer, Equities

William J. Monroe, CFA

Portfolio Manager, Putnam Small Cap Growth strategy

The makeup of the small-cap growth universe can change dramatically over time, making it challenging for investors who use indexes as their guide. As share prices fluctuate, so do market capitalizations. In the past 12 months, we have seen some companies in the Russell 2000 Growth Index grow to more than $30 billion — far larger than many names in the large-cap indexes. Capital structures also shift over time, as do measures of what constitutes a growth stock. Many companies in “growth” indexes have yet to generate revenue.

A few facts may surprise those who are not immersed in the small-cap growth universe:

Technology does not dominate the space. We’ve seen decades of intense focus on the technology sector and the changes that technology has brought to our lives. Many investors assume that dynamic new software companies would represent the bulk of small-cap growth stocks. In fact, as of May 2021, technology stocks comprise a larger portion of the S&P 500 Index (25%) than the Russell 2000 Growth Index (20%).

Healthcare is the largest sector. The weighting of healthcare stocks in the Russell 2000 Growth Index has grown by over 10 percentage points since 2011. Nearly all of this increase has been in biotechnology and pharmaceuticals — whose weighting dwarfs that of software in the small-cap index. We believe healthcare offers many growth opportunities, as the pace of innovation is so rapid.

Four sectors make up more than 80% of the index. Healthcare, technology, consumer discretionary, and industrials are currently the four largest weightings. Each of the other sectors represent less than 4% of the Russell 2000 Growth Index.

The small-cap universe has changed over time

Why we look beyond the index

We believe it is important to focus on what drives stock prices over longer time periods, and then apply that to our active, fundamental research of individual companies. In the short term, stock prices can fluctuate, often dramatically, based on factors ranging from macroeconomic readings, weather, commodity prices, short-term earnings reports, or simply technical trading imbalances. Over longer periods, however, we believe stock prices are correlated to the underlying growth in profits of a business.

In our small-cap growth portfolios, we seek to target companies that can grow profits at high rates for long periods, and we seek to pay a reasonable price for that growth. Ideally, we want companies with earnings growth rates over 15%, which could enable them to double in size within five years. This, of course, is a tall order. On average for the broader market, companies grow their earnings at 6% to 8%, and U.S. gross domestic product has grown at approximately 4% to 5% over the past 25 years. In 2021, many companies are likely to experience considerably higher earnings growth rates coming out of the pandemic. However, we believe the market is unlikely to reward earnings growth that is based purely on a post-pandemic rebound. Rather, companies that offer sustainable growth potential through market cycles offer the greatest potential, in our view.

Retail: Where earnings power translates to stock performance

For small-cap companies, retail has been an incredibly difficult area for decades. The power of much larger retailers has made it very hard to compete. However, some retail concepts have beat the odds and grown very profitably over the years.

At the core, we aim to find high-earnings-growth retailers. In our research, we break down the drivers of earnings power into pieces. First, we want to see growth in the number of stores. Second, and more important, we want to see higher per-store sales. Many companies can open stores over the course of a few years. However, if the unit economics are poor, we believe they need to stop expanding. We look for retailers that can more than double their store bases, so that earnings may more than double over time.

Stock stories: Critical attributes for long-term growth

As small-cap managers, we cannot invest in every company that meets these criteria, but we inform our research by looking at what has been successful for larger companies. Two long-term holdings in our portfolios illustrate our approach in the retail sector. While these companies offer very different products, they share attributes that we believe are critical for compelling long-term growth potential.

One is a value retailer targeting a younger clientele with a vast array of quality merchandise. We believe the company’s focus on teen and tween consumers and low-priced items helps to insulate it from online competitors. We also believe the company will be able to grow quickly while maintaining high margins and returns on capital.

The other holding is a specialty retailer that sells western and work apparel. We believe its products are more conducive to in-person purchases, which can insulate it from online price competition. The company was able to open some stores in 2020, and we believe unit growth should accelerate in 2021.

We believe these are examples of businesses that have the ability to maintain high margins and returns, which together may fuel high unit expansion plans. We believe both businesses should be able to compound earnings at over 15% for many years to come.

The Russell 2000 Growth Index is an unmanaged index of those companies in the small-cap Russell 2000 Index chosen for their growth orientation. The S&P 500 Index is an unmanaged index of common stock performance. You cannot invest directly in an index.

Frank Russell Company is the source and owner of the trademarks, service marks, and copyrights related to the Russell Indexes. Russell® is a trademark of Frank Russell Company.

Unless otherwise noted, data is as of May 31, 2021. Market commentary is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. Stock stories are intended to help illustrate the investment process and should not be considered a recommendation to purchase or sell any security. It should not be assumed that any investment in these companies was, or will prove to be, profitable, or that the investment decisions we make in the future will be profitable or equal to the investment performance of companies referenced herein.