Portfolio managers Jackie Wagner and Jeff John are back by popular demand. Cumulatively, they have beaten their benchmarks over the past five years, highlighting the potential for active management in the small-cap space.

When Jackie and Jeff first faced off in May 2020, the market had just bottomed after COVID-19. We didn’t know it at the time, but small-caps were about to start an epic run over large-caps.

Within small-caps, growth established a formidable lead over value during the initial bounce off the bottom, but value has far outpaced growth since ‘Pfizer Day’ in November 2020.

The underlying question for this debate was, “Do you stick with value, or is it time to cash in and buy the dip in growth?”

Hear what two of our top portfolio managers have to say about how their investment style will fare going forward. Read key takeaways from the replay below.

Key Takeaways

Valuation Is Never a Thesis, But It Is Our Friend

Small-caps overall are down about 30% from the peak last year and are cheap when looking at free cash flow generation and earnings yield. The Russell 2000 is trading at a compelling discount to its historical average, and the spread between small-cap and large-cap valuations hasn't been this wide in over 20 years.

Free cash flow has always been a driver of small-cap investing. In this later portion of the cycle, we’re seeing that it’s providing a mechanism for great management teams to allocate capital to its best and highest use.

Small Cap Value—Not a Hope Trade

Jeff: Small-cap value investing isn't a hope trade. When we uncover companies with quality cash flows, balance sheet strength and attractive valuations, we find that they provide a backstop to volatile markets. It’s what allows us to come back and fight another day, and we believe it sets us up for better risk-adjusted returns over time. Moreover, inflation and higher interest rates historically have been better for value over time versus long duration assets.

Higher Rates May Benefit Banks

Higher rates generally are good for spread businesses like banks, which make up about 20% of our index. And we think there are still opportunities in the industry if you look deeper. For instance, while many small-cap value managers naturally are underweight the energy sector, there is opportunity to benefit from its performance by exposure to Texas banks.

Small Cap Growth—The World Is Our Oyster

Jackie: Small-cap growth still maintains a lead over small cap value over the last 10 years. And the reason growth has outperformed is that growth companies view the world as their oyster. They have more control over their own destinies—they're not tied to GDP growth, monetary policy or fiscal stimulus. Basically, they have the potential to generate earnings growth regardless of the macro backdrop.

Investing in Innovation

One of the key ways we see small-cap growth winning out over the long term is through companies spending on innovation and disrupting their industries. For example, biopharma, a volatile industry, as seen in recent underperformance, yet it has become a substantial weight in the benchmark. While the risks are considerable, many smaller biopharma companies have produced positive returns over time. They’ve done this through rapid advances in technology and creating new ways to treat life-threatening diseases. We’re looking for companies that can continue to grow, take market share and have the potential to outperform over different market environments.