Wall Street week ahead: Fund managers navigate 'Night of the Living Dead' in small caps

NEW YORK: Investors are searching for bargains in the world of US small-caps, as the beaten-down asset class prepares for what may be the worst earnings season in its history amid a resurgent coronavirus pandemic.

Small-cap companies are expected to post a year-over-year earnings declines of approximately 90% as companies report their second-quarter results over the next several weeks, compared to a 67% hit for mid-caps and 44% for large-caps, according to Jefferies. That would be the largest drop since the fourth quarter of 2008, data from S&P Dow Jones Indices showed.

While some investors had counted on a third-quarter rebound, many are now concerned that potential coronavirus-fueled economic shutdowns in California, Florida and Texas will deal a disproportionate hit to smaller firms, which are more directly tied to domestic spending and have been among the biggest beneficiaries of stimulus measures delivered by the Federal Reserve and Congress.

People fear a "'Night of the Living Dead' of small-cap companies that would otherwise go bankrupt without the benefit of the stimulus and record-low interest rates," said Brian Jacobsen, senior investment strategist at Wells Fargo Asset Management.

Small-cap stocks are often considered a barometer of investor sentiment and tend to be among the first to recover in an economic revival. Their lackluster performance this year has led to concerns over the sustainability of a nascent recovery in unemployment and other key metrics after devastating declines.

The Russell 2000 index of small-cap companies is down approximately 12% for the year to date, compared with a less than 1% decline in the S&P 500 index, according to Refinitiv data. The Russell 2000 is up just 16.5% over the last 5 years, compared with an approximately 52% gain in the S&P 500.

There are signs that recent economic gains may already be faltering. Real-time measures of the economy such as retail foot traffic and employee work hours have stalled recently, as states have implemented new restrictions to try to halt the spread of coronavirus pandemic.

Still, some investors believe a patient approach will win out over time.

Jon Christensen, a portfolio manager at Kayne Anderson Rudnick, said the recent jump in coronavirus cases will likely make small-caps more volatile until there is a vaccine or effective treatment.

As a result, Christensen is buying companies he believes will outperform over the next three years, despite recent hits to their share prices. He recently added shares of daycare provider Bright Horizons Family Solutions Inc, which are down 23.1% for the year to date.

"Over the long term, even if we have more people working from home we know that Bright Horizon centers will continue to benefit from people needing childcare away from home," he said.

Joe Van Cavage, a portfolio manager at Intrepid Capital, is focusing on companies that were gaining market share ahead of the economic shutdowns. He has purchased shares of discount retailers Burlington Stores Inc and Ollie's Bargain Outlet Holdings Inc, which he believes could benefit from a prolonged economic recession as consumers trade down and spend less.

With fewer companies providing earnings guidance, "we say 'Let's stay on the edge of the storm and see what we can scoop up and not fly into the middle and try to hold onto dear life," he said.