With record 94.8% returns over the past 12 months—the second best in the history of the Russell 2000® Index—and on the heels of one of the worst quarters since inception in 1984 (-30.6% return in the first quarter of 2020), U.S. small-caps continue to attract attention from market participants around the globe. And for good reason: U.S. small-caps, often considered the bellwether of the U.S. economy, seem poised to benefit from a potential postpandemic rebound. Recent record returns conceal important changes in the composition of the U.S. small-cap universe. The profitability of the U.S. small-cap indices has deteriorated dramatically as companies with no earnings and the smallest of the small (penny) stocks have posted attractive performance since the onset of the pandemic. Junk rallies occur from time to time and have an impact on benchmark relative returns in the short run. A recent study by Furey Research Partners shows that small-cap core active managers have had the worst 12-month performance in three decades. However, if history and common sense are any guide, the case for small-cap investing remains valid as ever, and maybe even more so in light of the dislocations caused by this junk rally, which has ultimately created an attractively priced cohort of high-quality stocks. A dedicated U.S. small-cap mandate with high active share, focused on high-quality stocks and mitigating downside risks, may enable investors to capitalize on the long-term potential found in U.S. small-cap stocks. A YEAR OF HIGH RETURNS AND LOW QUALITY Outperformance by unprofitable companies pushed weight of nonearners to all-time highs. During 2020, companies with no earnings outperformed companies with earnings by 45% (Exhibit 1). As a result of this success, approximately half of companies in the Russell 2000® Growth Index (R2G) by weight, and more than half by number of stocks mades zero earnings (Exhibit 2). In March 2021, we started to see nonearners’ performance roll over, which is more in line with historical averages; for the 2001–2021 period, earners outperformed nonearners by 3% on an annualized basis.1 Exhibit 1: Performance of earners vs. nonearners Source: FactSet Research Systems; Russell Investment Group; Jefferies. Note: 2001-2021 period is annualized. Exhibit 2: Nonearners as percentage weight and percentage of number of stocks in R2G Source: FactSet Research Systems; Russell Investment Group; Jefferies. Concentration in Biotech and Tech. Biotech and technology have established tremendous dominance in the R2G. As of the end of the first quarter of 2021, biotech comprised over half of the total health care weight in the index and, together with pharmaceuticals, it comprises nearly 66% of the sector. Health care and technology, the only true areas of outperformance for the benchmark during 2020, are now over 50% of the R2G (Exhibit 3). The strong price appreciation has resulted in a commensurate rise in valuations and a tsunami of new deal issuance in these areas. Exhibit 3: Sector composition of R2G Source: FactSet. GICS Sectors. Data as of March 31, 2021. The Smallest Lead. Strong flows into passive small-cap exchange- traded funds, estimated at $12 billion for the first quarter of 2021 and $24.4 billion since the start of November,2 propelled the smallest of the small-caps (under $1 billion market capitalization stocks). They outperformed by 6.6% in 2020 and 2.5% during the first quarter of 2021, countering the historical average of 3.4% annualized outperformance by the largest small-caps.3 Exhibit 4: Largest and smallest stock performance quintile Source: FactSet Research Systems; Russell Investment Group; Jefferies. THE CASE FOR AN ACTIVE U.S. SMALL-CAP ALLOCATION The case for a dedicated active U.S. small-cap allocation is rooted in fundamental financial principles, not on the ebbs and flows of the small-cap universe. If anything, dislocations such as the ones experienced over the past year enhance potential opportunities for the thoughtful investor. Potential for Alpha. A larger, more idiosyncratic and more diverse universe, with less information availability than its large-cap counterpart, U.S. small-caps exhibit high return dispersion across stocks (Exhibit 5) and sectors (Exhibit 6), a necessary condition for good stock picking. Exhibit 5: Dispersion in stock returns for the Russell 2000® Index, three-year trailing return for top and bottom quartile, by year since 2011, and average and median 1991–2020 Source: Furey Research Partners. Exhibit 6: Dispersion in sector returns, Russell 2000® Index Source: Furey Research Partners. Note: Bars indicate the range of returns across GICS sectors in the Russell 2000® Index, with the bottom end of the bar representing the return for the worst performing sector in each year, and the top of the bar representing the return for the best performing sector in each year. The dot represents the Index return. Often receiving less attention than larger-cap markets, inefficiencies in small-cap space tend to persist or be arbitraged at a slower pace. Analyst coverage varies with cap range; while there is an average of 20.2 analysts per stock in large-cap, there are 14.3 for mid-cap and only 5.6 in small-cap (Furey Research Partners). Breadth. With over 2,000 stocks, access to financing and a highly innovative economy and culture, U.S. small-caps comprise the largest opportunity set within global small-caps. In fact, U.S. smallcaps represent over half of the global small-caps universe. Deep and liquid market structure. High governance hurdles for listing in the stock market and a better overall governance relative to its counterparts in the rest of the world make U.S. small-caps particularly attractive, especially from a risk management perspective. Furthermore, U.S. small-caps are a much deeper and liquid market. BROWN ADVISORY U.S. SMALL-CAP GROWTH, WITH A FOCUS ON QUALITY Focusing on quality is an ever more important consideration amid the deterioration in the overall quality of the small-cap universe. Market dislocations such as the one experienced over the past year can generate an environment that is typically favorable to our style of investing. We believe that there are three key pillars to capitalizing on the broad opportunity set offered by U.S. small-caps over the long term: High active share. We believe that low-turnover, relatively concentrated portfolios that reflect our best thinking create the best opportunities for outperformance over a full market cycle. Only by being different from the broader market can we achieve attractive excess returns and avoid the ebbs and flows of the benchmark, which can be hazardous in absolute terms. Consistent high-quality bias. As long-term investors, we harness the power of compounding and therefore seek small-cap companies with the ability to scale into much larger business franchises in the future. Our philosophy naturally embeds a quality bias. For each investment, we seek out durable growth, sound governance and scalable go-to-market strategies. With our thinking anchored as long-term business owners as opposed to renters of stocks, we establish a high hurdle to enter the portfolio. For this reason, we skew higher in quality than our most often quoted benchmarks. Mitigate downside. Our portfolio construction is built on a holistic diversification that takes into account many different variables, including sector, subsector, cyclicality, profitability, valuation and balance sheet strength. This is intended to tamp down the topdown (or beta) effects of the portfolio, enabling our alpha to be driven by our bottom-up security selection. In addition, we follow a strict valuation discipline, which requires us to understand risk/return trade-off in every investment, and size positions accordingly. Investment, fundamentally, is about the price you pay for the value you get. We try not to forget this fact. “Size Matters If You Control Your Junk,” Asness et al. (2015) document that small-cap companies outperform the market if low-quality companies are avoided. Furey Research Partners. Jefferies. The views expressed are those of Brown Advisory as of the date referenced and are subject to change at any time based on market or other conditions. These views are not intended to be and should not be relied upon as investment advice and are not intended to be a forecast of future events or a guarantee of future results. Past performance is not a guarantee of future performance and you may not get back the amount invested. The information provided in this material is not intended to be and should not be considered to be a recommendation or suggestion to engage in or refrain from a particular course of action or to make or hold a particular investment or pursue a particular investment strategy, including whether or not to buy, sell, or hold any of the securities mentioned. It should not be assumed that investments in such securities have been or will be profitable. To the extent specific securities are mentioned, they have been selected by the author on an objective basis to illustrate views expressed in the commentary and do not represent all of the securities purchased, sold or recommended for advisory clients. The information contained herein has been prepared from sources believed reliable but is not guaranteed by us as to its timeliness or accuracy, and is not a complete summary or statement of all available data. This piece is intended solely for our clients and prospective clients, is for informational purposes only, and is not individually tailored for or directed to any particular client or prospective client. All investments involve risk. The value of the investment and the income from it will vary. There is no guarantee that the initial investment will be returned. An investor cannot invest directly into an Index. Definitions of indices used are below. The Russell 2000® Index measures the performance of the small-cap segment of the U.S. equity universe. The Russell 2000 Index is a subset of the Russell 3000 Index representing approximately 10% of the total market capitalization of that index. It includes approximately 2,000 of the smallest securities based on a combination of their market cap and current index membership. The Russell 2000® Growth Index measures the performance of the small-cap growth segment of the U.S. equity universe. It includes those Russell 2000 companies with higher price-to-value ratios and higher forecasted growth values. The Russell 2000® Growth Index and Russell® are trademarks/service marks of the London Stock Exchange Group companies. London Stock Exchange Group plc and its group undertakings (collectively, the “LSE Group”). © LSE Group 2019. 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