Smaller Stock Opportunity Could Deliver Big for Clients

Entering this year, one of the prevailing expectations was that smaller stocks, both mid- and small-caps, would outperform their larger rivals. A month and a half into 2023, that scenario is playing out.

As of Feb. 17, the small-cap Russell 2000 Index is higher by 10.8% year-to-date while the S&P MidCap 400 Index is up nearly 10%. That while the large-cap S&P 500 is up “just” 6.5%. Obviously, it’s still early in 2023, but those data points confirm smaller stocks aren’t just on the mend, they’re displaying leadership qualities as well.

Predictably, the Federal Reserve figures prominently in the small-cap equation and while some clients are apt to think the central bank is problematic for smaller stocks, advisors can and should inform about important factors. Namely, all those interest rate hikes are boosting the U.S. dollar, which is great for smaller companies that generate substantial portions of their sales on a domestic basis.

That’s notable when considering the Fed’s eight rate hikes since the start of last year aren’t yet showing the expected level of effectiveness in damping inflation. See the January reading of the Consumer Price Index (CPI). With that in mind, there are a variety of compelling reasons to consider smaller equities today.

It’s Cheap to Get Involved

An often cited knock against smaller equities, particularly small-caps, is that they are richly valued compared to large-caps. That’s simply the price of admission for accessing the growth attributes offered by smaller companies.

However, those lofty valuations aren’t a factor today. In fact, current mid- and small-cap valuations relative to large-caps are as low as they’ve been in 20 years.

“Despite a long history of outperformance versus large–caps, valuations for SMID–cap companies have taken a noticeable haircut relative to large–caps over the past few years,” according to VanEck research. “SMID cap valuations began to diverge back in 2018 and then saw further discounts at the beginning of 2021. Driving forces behind the widening discount during this period include the aging of the previous record–setting bull market, growing concentration within the equity market in mega–cap companies, and different sector compositions of the U.S. large and small–mid cap indices.”

Returning to the issue of the Fed, which may have to raise rates more than expected this year, VanEck points out that tighter monetary policy is a credible catalyst for smaller equities.

“However, investors should consider the change in monetary environment and turmoil in markets as an opportunity to position for long–term growth. Valuations for small– and mid–cap companies, in terms of forward price–to–earnings, are now at 20–year lows relative to large caps. Pair this extreme valuation discount with eventual brighter days in terms of macro backdrop, and we believe SMID cap stocks may prove to be rewarding for patient investors,” adds the fund issuer.

Attractive History

As is often noted in this space, past performance is not a guarantee of future returns and market history doesn’t always repeat, but it often rhymes.

All that said, the history of mid- and small-cap out-performance of larger stocks is something to behold, including over the three-, five- and 10-year monthly rolling periods.

“Looking at 10 year monthly rolling periods, SMID–cap equities have outperformed large–caps over 70% of the time since January 2000. While past performance is not a predictor of future outcomes, this data provides a favorable historical foundation for assessing the track record of small– and mid–cap stocks,” concludes VanEck.

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