By Lori Ioannou
With inflation falling and the Federal Reserve expected to cut interest rates as soon as its policy meeting later this month, the headwinds that have beset small-cap stocks for the past few years are poised to fade.
Small-caps are more sensitive to U.S. interest rates and economic conditions than large-cap stocks since they tend to have more debt and rely more on bank financing to fund their operations. In addition, small-caps are often more domestically focused than large-caps and struggle when American consumers are pinched by inflation or a struggling economy.
"Small-cap stocks, hurt by inflation and rising interest rates in the U.S., have underperformed and were ignored by many investors," says Nick Kalivas, Invesco's head of factor and core equity ETF strategy, who notes small-caps have been laggards for a decade. Since Aug. 1, 2014, through Aug. 1, 2024, the Russell 2000 index of small stocks has returned 8.91% annually compared with returns of 15% on the large-cap S&P 500.
So far this year, small-caps continue to be outshined by their larger brethren. For the year through Aug. 30, the S&P SmallCap 600 Index and the Russell 2000 index of small stocks are up 8.4% and 10.4%, respectively, while the S&P 500 has returned 19.5%.
But analysts and investors are increasingly optimistic about small-caps' potential to outperform large-caps in the months ahead, driven by the likelihood that the U.S. won't fall into a recession and that interest rates will fall by as much as 1.5 percentage points by the end of 2025, says Sam Stovall, chief investment strategist at CFRA Research. "According to Wall Street analysts' earnings estimates, stocks on the S&P SmallCap 600 are expected to see a 22.1% rise in earnings in 2025 versus 14.8% for the S&P 500," he says.
What's more, investors have begun to buy into the small-cap case. Small-cap exchange-traded funds have taken in a net $25.1 billion for the year through Aug. 30, almost triple the $9.4 billion invested during the same period in 2023, Morningstar Direct reports.
Financial advisers caution that small-caps pose unique risks and costs for individual investors.
"Small-caps are more volatile than large-cap companies and they are less liquid so they can be expensive to trade on your own," says Bill Hench, portfolio manager of First Eagle Small Cap Opportunity Fund (FESCX), a $1.9 billion small-cap value mutual fund. "They are not tracked as much as large companies by financial analysts and institutions, and the available research on these stocks is usually limited."
A beaten-down sector
Over the past few years, small-cap stocks have been eclipsed by megacap tech growth stocks known as the Magnificent Seven -- Amazon.com, Apple, Google parent Alphabet, Facebook parent Meta Platforms, Microsoft, Nvidia and Tesla -- which hold a disproportionate influence on the Nasdaq Composite Index and S&P 500 because of their huge market capitalizations. Many investors plowed into these stocks driven by their financial performance and innovation in artificial intelligence and other areas, which have significant growth potential.
Now, investment strategists say, small-caps are selling at historically low valuations versus just about every other stock grouping, making them a diversification play. As of Aug. 30, the forward 12-month price-to-earnings ratio for the S&P SmallCap 600 is 16.9, compared with 22 for the S&P 500.
"Small-caps are cheap so it's a good time to buy," says Mike Palmer, managing principal of Ark Royal Wealth Management. He says that for many investors, this may seem like a contrarian play considering that the Magnificent Seven continue to power the market. "But the bull run in these megacaps may not go on forever," he says.
Diversifying your risk
Given the risks of buying individual small-cap stocks on your own, many analysts and investment advisers say individual investors who want to invest should consider buying low-cost ETFs or mutual funds that track a small-cap index.
"These offer a wide berth of small-cap stocks across industry sectors, so investors get broad equity diversification," says Zachary Evens, manager research analyst at Morningstar Research Services. For example, the $2.9 billion Vanguard S&P Small-Cap 600 ETF $(VIOO)$, invests in all companies on the S&P SmallCap 600 and no single company makes up more than 0.64% of total assets. Its expense ratio is 0.1%.
Keep in mind there are key differences between small-cap indexes used to construct ETFs. The Russell 2000 -- a broad measure of the small-cap universe -- tracks 2,000 U.S. companies with a median market cap of $963 million and is reconstituted annually except when initial public offerings meet the eligibility criteria. The S&P SmallCap 600 includes companies with a median market capitalization of $2 billion that have a record of positive earnings for the most recent four quarters. It is reconstituted on an as-needed basis.
There also is the CRSP U.S. Small Cap Index, an index of about 1,400 U.S. small-cap stocks that have a median, float-adjusted market cap of roughly $3 billion. Many investors aren't familiar with this index developed and maintained by the Center for Research in Security Prices, an affiliate of the University of Chicago. The index is reconstituted quarterly and requires that at least 12.5% of shares outstanding are traded publicly. The $59.3 billion Vanguard Small-Cap ETF $(VB)$ tracks the CRSP U.S. Small Cap Index with an expense ratio of 0.05%.
"Screening for profitability is important if you are investing in small-caps," says Kevin Gordon, senior investment strategist at Charles Schwab, who notes that 40% of the stocks on the Russell 2000 are companies with no earnings. "So is screening for high interest coverage, which is the ability to pay interest on company debt, since a sizable decline in interest rates will take time."
Index ETFs offer different approaches to small-cap investing. Some like the $11.8 billion iShares Russell 2000 Growth ETF $(IWO)$ focus on growth stocks -- companies that have demonstrated better-than-average gains in earnings and have high profit-growth potential. Others like the $30.1 billion Vanguard Small-Cap Value ETF (VBR), that tracks the performance of the CRSP Small Cap Index, focus on value stocks -- undervalued companies with good fundamentals.
There are also a variety of other investment styles small-cap ETFs use, such as momentum trading and dividend investing.
Ultimately, investing in small-cap stocks is a long-term play and can take time to realize substantial gains, says Robert Harvey, a certified financial adviser and vice president at Dimensional Fund Advisors, an investment firm known for small-cap investing that applies academic research on market behavior.
"When evaluating a fund, look at the track record of the fund's manager and the fund's long-term performance," he says.
Lori Ioannou is a writer in New York. She can be reached at reports@wsj.com.
(END) Dow Jones Newswires
September 06, 2024 10:00 ET (14:00 GMT)
Copyright (c) 2024 Dow Jones & Company, Inc.
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