Small-cap stocks are perking up. Here's how to pick winners.

MW Small-cap stocks are perking up. Here's how to pick winners.

By Isabel Wang

Investors looking to broaden their exposure to small caps may want to be selective in sector allocation, strategists say

A mad rush for U.S. small-cap stocks over the past week has investors weighing whether to chase the rally or proceed with caution in one of the most speculative corners of the stock market.

The small-cap benchmark Russell 2000 index RUT - which measures the performance of 2,000 small and midsized companies included in the Russell 3000 index RUA - rose 11.5% over the five trading sessions ending Tuesday, marking its largest five-day percentage gain since April 2020. The advance also pushed the index to its highest level in two-and-a-half years earlier this week before it gave back some of its gains on Wednesday, according to Dow Jones Market Data.

See: Small-cap stocks get some revenge after Big Tech rally pauses. How long can they keep it up?

The surge was also pronounced in some of the small-cap-focused exchange-traded funds tracking stocks in the financials, healthcare and industrials sectors. The SPDR S&P Regional Banking ETF KRE on Thursday rose for the ninth straight trading day, something it hasn't done since November 2018, according to Dow Jones Market Data.

The SPDR S&P Biotech ETF XBI on Tuesday jumped nearly 2% to close at its highest level since February, before giving back that advance in the following days. The iShares U.S. Industrials ETF IYJ also gained more than 2% on Tuesday to score its best day in over a year, according to Dow Jones Market Data.

Yet investors looking to broaden their exposure to this long-suffering corner of the market may want to be selective in sector allocation within small caps, as this rally could be "misleading" for long-term investors, according to market strategists and portfolio managers.

"What we have seen in the last five trading days [ending Tuesday] is nothing short of spectacular and historical ... but there's nothing that has fundamentally happened [to those small-cap companies] that in any way explains the move of these stocks," said Brett Reiner, managing director and portfolio manager on the small-cap team at Neuberger Berman.

To be sure, the recent move in small caps appears to be triggered by data showing greater disinflationary progress - especially last week's June consumer-price index, which many believe makes it almost a certain that the Federal Reserve will lower interest rates in September.

The so-called "Trump trade" is another piece of the puzzle. The increased likelihood that former President Donald Trump could win the upcoming U.S. presidential election is favorable for small caps, as his proposed policies include reducing the corporate tax rate to as low as 15%, from a current 21%, and seeking to reduce the power of financial regulators.

"If we have business-friendly policies, you might see a rally similar to 2016 when Trump won - the junk-stocks rally - so there is a component of this anticipation of friendly policies that is also being priced into the small-cap market right now," said Anna Rathbun, chief investment officer at CBIZ Investment Advisory Services.

See: These small-cap stocks score highest when screened for quality

A rising tide lifts all boats - but regional banks and biotech companies sail ahead

Shares of financials and biotechnology firms are two of the larger components of the small-cap landscape, with each representing around 15% and 9% of the Russell 2000 index, respectively, according to FTSE Russell, a subsidiary of London Stock Exchange Group.

However, strategists said the liftoff in these sectors is the result of "a tide that raises all the boats" and only underscores how sensitive these segments of the small-cap market have been to the interest-rate backdrop, U.S. economic conditions and Fed policy.

In theory, lower interest rates are expected to boost the profitability of regional banks by reducing the interest they pay depositors and triggering a pickup in loan demand. However, that "doesn't mean it's all rosy for regional banks and small caps," given a "still-challenging economic environment," noted Paul Baiocchi, chief ETF strategist at SS&C ALPS Advisors.

Meanwhile, biotech companies - many of which are involved in the process of developing life-changing medical treatments and technologies - are known for their high volatility in the stock market, as their potential for significant returns is driven by breakthroughs in clinical trials or drug-discovery processes. They also face regulation from the likes of the Food and Drug Administration, adding to the risk of uncertainty surrounding the development of new drugs.

"Biotech companies are effectively lottery tickets with the FDA," Reiner told MarketWatch in a phone interview on Wednesday. "These are one or two drug companies that financially tend to lose money [and] burn through cash, so the best backdrop for such companies is to have very accommodative capital markets, where rates are low, that could help finance their growth."

The recent rally in biotech names appears to have seen them "completely benefiting from the expected lower-rates environment," instead of "anything significant happening within that industry" or on the regulatory front, Reiner added.

Active strategy is the way to go

As a result, strategists said that investing in small-cap ETFs with a cap-weighted or an index-based approach has drawbacks, because investors might catch in their nets some of the worst operators in an already debt-laden segment of the market.

Small caps usually hold higher debt burdens than large caps as measured by net debt-to-Ebitda, which indicates how long a company would need to operate at its current level to pay off its debt. The net debt-to-Ebitda ratio for the iShares Russell 2000 ETF IWM was 3.69 times over the last 12 months, compared with 1.63 times for the large-cap S&P 500 SPX in the same period, according to FactSet data.

"If investors want exposure to small caps, we do think active strategy is the way to go," Reiner said, noting that while small caps offer "inherent risk" when investing in a benchmark, active management - particularly geared toward quality orientation - could benefit from the attractive valuations and faster earnings growth of some small caps, without the risks associated with passive investing.

SS&C ALPS Advisors' Baiocchi also suggests investors to take a "more conservative tact" when approaching small caps, while honing in on companies that do have profitability, lower leverage and well-covered dividends so they have "some insulation from the inherent volatility of the small-cap segment," he told MarketWatch.

U.S. stocks were trading lower on Thursday, with the technology sector struggling to claw back losses from the previous session.

The Russell 2000 and Russell 3000 indexes were off 1.2% and 0.7%, respectively, whil blue-chip Dow Jones Industrial Average DJIA was down 1%, the S&P 500 was losing 0.7% and the Nasdaq Composite COMP was falling 0.8%

-Isabel Wang

This content was created by MarketWatch, which is operated by Dow Jones & Co. MarketWatch is published independently from Dow Jones Newswires and The Wall Street Journal.

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July 18, 2024 14:19 ET (18:19 GMT)

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