Earnings Growth and Valuation Gaps Fuel the Small Cap Rally

SPEAKER_1 (0:00)

Let's talk about these markets. Joining us now is Elena Khoziaeva, who's the Co-Chief Investment Officer at Bridgeway Capital Management. Elena, thank you so much for your time. Always lovely to check in with you. I'm just wondering, you know, as far as diversification in this market, how are you looking to play that both geographically and down cap?

Elena Khoziaeva (0:19)

Good morning. Absolutely, there's so much going on right now. We have a rise in oil prices. We have interest rates rising. We have the rallies that start really quickly, and then they pull back. So the diversification is important now more than ever.

And while the global and emerging markets remain the diversification lever, and they've performed really well in this environment, it is also important to look in the small cap space. And that's why we're talking about the cap spectrum. So both diversifying geographically and from the size standpoint is crucial right now.

SPEAKER_1 (0:57)

And what about thematically? I mean, are you looking to continue to play AI with EM and down cap, or is this a way to at least hedge technology as well?

Elena Khoziaeva (1:10)

Well, the technology is dominant in the large cap growth space, but there is also a lot of players that can benefit from AI development in a small cap space, both value and growth space, as well as in the emerging markets. Absolutely. You've seen what happened in July with a strong comeback in the months of August and September.

There are players that are benefiting from the AI exposure in both different countries, as well as in a small cap space. But we do not take the specific approach of leveraging these themes. It's actually why we're talking about the diversification staying disciplined to the process that we develop. Having advisors be disciplined, having investors be different is crucial. So it is less over the AI play, and it's more about what research is telling us about the small cap devaluation, as well as what's very crucial right now, the earnings growth that's telling us to look in different, and ask investors to look in different spaces.

SPEAKER_1 (2:11)

And what are those? I mean, particularly given the strength we've seen in Q2, I guess the bar has been significantly raised for this next earnings season.

Elena Khoziaeva (2:22)

We've seen some really strong numbers.

I looked back in predictions in January 2025, and that's where the analyst expected the Russell 2000 earnings growth be in a, kind of, historical 10 percent level. There was some expectation of it going to the 20 In the first quarter of this year, we've seen Russell 2000 earnings growth be at 35 percent year over year.

In the second quarter, the number grew to roughly 43 percent. That's significantly beating the previous expectations. If we should continue to see this potential going forward, in addition to the valuation gap that continues between the small cap and large cap, that would be the evidence in favor of this rally or this stronger performance of the small caps be sustainable and repeatable in the future, the combination of the earnings growth and the valuation gap.

SPEAKER_1 (3:15)

And what's the playbook for diversifying away from equities right now, particularly with respect to duration and what the Fed has done and is likely to do?

Elena Khoziaeva (3:28)

Well, so this is the environment that we've seen right now is the perfect opportunity to look at the market neutral strategies.

That's where the strategies that offer the low or zero correlation to the environment, they're not dependent on the rising interest rates. And at the same time, they provide a steady returns with low volatility. That's a great alternative to fixed income. So instead of playing the duration book, take a look at the market neutral strategies that offer a great alternative.

SPEAKER_1 (4:00)

Okay, and just last year, Elena, what are you watching this week given that earnings and I guess the data takes a little bit of a backseat for now as we focus on the macro and the geopolitics?

Elena Khoziaeva (4:12)

I would say that the quarter is coming towards the end. So there are some events that are taking place.

I am all eyes and ears for the next earnings season. So as I mentioned, this earnings growth and whether this continues in post the quarter and that's something that's going to be crucial for this continuation of the small caps. So nothing specifically this week, I would say. And again, we follow our discipline process and rebalance into the targets. But the next earnings season would be some interesting development.

SPEAKER_1 (4:45)

We'll be watching. Really appreciate it as always. Thank you so much for kicking off the week with us here. Elena Khoziaeva, Co-Chief Investment Officer at Bridgeway Capital Management.