After a great run in 2020, the Russell 2000 Growth Index has fallen into bear market territory. This key index is home to many of the fastest growing smaller companies in America. It has fallen more than 20% from its November high and the magnitude of the decline from a peak in February 2021 is now close to that that occurred during the recession in 2020. The sector performed spectacularly while the pandemic was raging as it is well populated with online business and other stay at home plays. Since the demise of the pandemic, however, investors seem to have preferred companies set to benefit from recovering global economies.

Newly public companies (also known as recent IPOs) have suffered even sharper falls as evidenced by the decline in the price of Renaissance IPO ETF which is a good proxy for this asset class. We’re very enthusiastic about the prospects for this area of the market as it tends to have the potential to be home to the undiscovered gems of the future. Companies like Starbucks and Salesforce.com were recent IPOs a few decades back, as was Amazon.

We’d point to a number of reasons why the sector has done poorly since the end of last year. They all centre on a market environment that has moved from “risk on” to “risk off” as investors worry about the impact of inflation and higher interest rates:

1) Newly public companies are at the far end of the risk spectrum. Their shares often have lower trading liquidity and large amounts of stock are typically closely held by early backers. This is a high beta sector and just a few large sellers can hurt stock prices.

2) Business models are relatively unproven: the sector features many companies which are not yet profitable. This makes them an ideal target for short sellers when market conditions are less favourable.

3) Companies that have recently listed have limited financial reporting histories for analysts to scrutinise. Some of the most severe share price markdowns we have seen have been for stocks listing within the last 12 months.

4) Valuations are often high as these new companies attract investors with forecasts of strong top line growth. We have seen sharp falls in richly valued stocks in the aftermath of higher long term treasury bond yields.

5) The high level of new issuance over the last two years has caused some “indigestion” as investors struggle to work out which ideas are the most exciting.

Key growth sectors including healthcare and technology have been under tremendous pressure. The S&P Biotechnology ETF has entered bear market territory having fallen more than 40% from its peak in February 2021. The trigger for the change in the prices investors are prepared to pay for companies in these sectors has been the back up in 10-Year Government Bond yields. This is an important component in how investors value growth companies as it provides the rate of interest used in models to establish the worth of earnings streams which are anticipated in the future. The low interest rate tailwind for growth stocks in the years prior to 2021 has become a headwind as yields have risen from 1.2% last summer to over 2% now.

The back up in bond yields has encouraged investors to buy cyclical stocks and the Russell 2000 Value Index of smaller companies has begun to significantly outperform the Russell 2000 Growth Index. The former features many companies set to benefit from the reopening of global economies. Growth stock underperformance has been exacerbated by sector rotation – investors selling pandemic winners/buying lower priced cyclicals. Stocks in the energy, basic materials, industrials, and banking sectors have been the big winners.

Somewhat encouragingly for small-cap growth investors, we may now be reaching a point where the severity of the drawdown has begun to make valuations look appealing again. The relative PE ratios of some of the key smaller cap indices compared to the large cap S&P 500 Index appear close to the record lows of the last twenty five years. In particular, the high growth software sector within technology has seen quite a de-rating to a point that is near the trough of valuations seen over the last several years. The sector was a major pandemic beneficiary as many constituents help businesses transact online.

What would really get the small-cap growth asset class motoring again, however, would be if investors begin to anticipate that inflationary pressures are peaking (suggesting less need for the Federal Reserve to raise interest rates aggressively) and that the yield on the US 10-Year Treasury Bond has already made most of its move higher. High growth stocks are currently considerably out of favour, and any change in investor sentiment has the potential to result in a sharp rally. Our enthusiasm for the sector remains undiminished despite the recent drawdown.