The Growing Case for Small-Cap Stocks: Is it Time to Make the Shift?
The more time that passes with small cap stocks lagging the large and mega caps, the louder very respected market voices are urging investors to move more assets to these smaller companies. The pro small cap stock outlook was reflected again in a recent Barron’s article. The piece highlighted what others continue to point out, that the large cap, S&P 500, is up nearly 8% on the year, but the gains have only been because of the performance of a few big tech stocks and the math used to measure the equity index.
A very eye-opening line in Barron’s points out that, “Apple (ticker: AAPL), Amazon.com (AMZN), Meta Platforms (META), Alphabet (GOOGL), Microsoft (MSFT), Nvidia (NVDA), and Tesla (TSLA) are up between 29% and 99% for the year.” These stocks make up a significant weighting of the large cap index, which means that much of the other large cap stocks have been negative in order to only provide an 8% return. To demonstrate how the weighting of the larger companies distorts return, just look at the Invesco S&P 500 Equal Weight ETF (RSP). This ETF weighs each stock in the S&P 500 equally. This has the effect of avoiding overweighting and one stock. This ETF is flat year-to-date. In contrast, The few tech names listed above total just under a third of the entire index.
The article also pointed out the truth that smaller names, those not in the S&P 500, have struggled. What does this mean for investors? Barron’s wrote, “They also look cheap—-and it may be time to take a nibble.” The case that others are also making is based on a number of current market setups. These include value, market history, and even macroeconomic trends that now may favor smaller companies over larger ones.
Big Tech companies like those mentioned above borrow massive amounts of money, they have been the beneficiaries of lower bond rates out on the yield curve. In addition to borrowing costs still below normal, valuing these stocks based on future earnings and comparing the expected earnings to available interest rates have caused investors to be less inclined to tie up money for ten years or more, (at 3.50%). Also, better than expected first-quarter earnings of big tech-inspired investors – product enhancements using artificial intelligence was credited with much of this.
Royce Funds’ Premier Quality Fund invests in “small cap quality.” In a recent article to investors co-lead portfolio managers Lauren Romeo and Steven McBoyle explained why, “small-cap quality looks so compelling in today’s uncertain investment environment.” The portfolio managers wrote, “Secular changes in economic trends, interest rates, and monetary and fiscal policies are creating seismic shifts in the investment landscape. The types of companies that benefited most from the past decade’s zero interest rate, low inflation, and low nominal growth regime—specifically, mega-caps and growth stocks—are unlikely to lead going forward.” Under this backdrop, the two gave their perspective which is that, “the unfolding macro environment appears to be set for quality small caps to capture and sustain long-term outperformance over large cap” through an uncertain period that is characterized by a near certain transition.
If tech stocks again falter because rates rise, advancement slows, or competition grows, the appearance of the S&P 500 large cap index stocks performing well could diminish. “Market gains continue to be dominated by uber-caps, masking the fact that 48% of S&P 500 member stocks are down year to date,” wrote Chris Harvey, chief U.S. equity strategist at Wells Fargo, on May 12.
Within the same index family (S&P), is the S&P 600, which is a small cap index. It is not currently having a positive year, and is down about 3%. Interestingly, the reverse argument can be made for this benchmark since it is overweighted in one specific sector. Financials, which have taken a beating this year is the largest sector weighting in the S&P 600. It accounts for just over a fifth of the performance. This has dragged the index lower, as regional banks have seen billions of depositor dollars walk out the door as savers and investors move assets to higher-yielding money-market funds. This, as we know, has caused liquidity problems at many banks, and caused some to fail.
2023 has been a challenging market for stocks despite the S&P 500 performance. It has been challenging for small caps too, but not as challenging as the S&P 600 performance would have one believe without looking under the hood. Small caps, independent of the high weighting of financials in the benchmark are positive on the year. One very real concern large cap investors are now facing is whether the flow into large cap funds have overly inflated the value, based on most stock valuation metrics, above where they would naturally trade if not for indexed funds.
The economy is not expected to get much stronger this year. Higher interest rates have already begun to stress the US economy, and banking problems are expected to cause tighter lending and consumer spending. And as mentioned a few times, the widely quoted S&P 500’s performance, is covering up what has mostly been a tough equity market.
But while large caps look expensive, for the reasons mentioned, respected experts say small caps look cheap. The S&P 600’s aggregate forward price/earnings multiple is just under 13 times – this compares with the S&P 500 which is 18 times. While on the surface, this doesn’t seem striking, it is! While the difference between 13 times and 18 times doesn’t sound wide, it marks a 30% difference. That is a massive discount. Historically the small cap index trades at a slight premium to its large-cap counterpart, but even in times of economic stress, it doesn’t trade at such a wide discount. In March of 2020, the height of pandemic risk aversion, its multiple was only 25% below the S&P 500.
Take Away
It has been a tougher year for stocks than the performance of the large cap S&P 500 would have one think without digging below the surface and netting out its largest sector weighting. The small cap S&P 600 is down, but largely because of its own largest sector weighting. This is one of the many problems inherent in how popular index investing has become. While stocks in general seem to be facing increasing headwinds, investors that selectively evaluate small cap names for inclusion in the equity portion of their portfolio may find the payoff is better than the alternatives.
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Managing Editor, Channelchek
Sources
https://www.barrons.com/articles/small-cap-stocks-big-tech-15df5779?mod=hp_LEAD_2