Believe It: Big Benefits with Smaller Stocks

Not surprisingly, smaller stocks aren’t providing investors with much shelter from broader market storms this year.

As of Oct. 4, the S&P 500 is down 19.5% while the small-cap Russell 2000 Index is off 20.1%. Give mid-cap stocks some credit because the S&P MidCap 400 Index is the “best” of the bunch with a 2022 decline of 16.1%. So no, smaller stocks aren’t anything to write home about this year.

However, those performances belie valuation opportunity and that’s something for advisors to ponder on multiple levels. First, small-cap value, over the long haul, is one of the most potent factor combinations. Second, mid-cap stocks outperform both large- and small-caps over the long-term, often doing so with less volatility.

Mid-cap stocks are often overlooked, but the group has an enviable track record – one worth highlighting – in tough market environments so it may not be surprising the group is less bad this year than large-cap rivals.

Bargains Abound with Smaller Stocks

As is often said, valuation alone isn’t a reason to buy or sell a security, but the valuations on smaller stocks – usually more frothy than large-caps – might just be getting to intriguing to ignore.

“Recent price weakness has left large-cap valuation metrics below their recent three-year averages. But small- and mid-cap stocks offer an even more compelling value. Relative to large caps, price-to-book ratios for smaller stocks are trading at roughly half of large caps,” according to ProShares research.

Advisors have strong fundamentals to lean on when it comes to discussing smaller stocks. While clients are apt to simply look at returns and come away pondering why small- and mid-caps are on the agenda, advisors can allay those concerns. Earnings quality prove as much.

“Deciphering exactly when the valuation gap may begin to close is difficult. One potential catalyst could be continued earnings strength. In the first quarter of 2022, both small and mid caps delivered solid earnings and sales growth that exceeded large caps; further, small and mid caps are expected to deliver better full-year numbers,” adds ProShares. “Granted, the earnings picture could change if the economy falls into a recession, but we believe first-quarter results were encouraging.”

More Reasons to Consider Smaller Stocks, Including Dividends

While small-caps are not doing so, mid-caps stocks are living up to the historical billing of smaller stocks outperforming amid rising interest rates.

Additionally, there remains overlooked dividend potency among both mid-cap and small-cap stocks – groups clients don’t often associate with growing, sturdy payouts.

“Often only thought of as large cap household names, dividend growers are also found among small- and mid-cap stocks. The S&P MidCap 400 Dividend Aristocrats Index, a group of mid-cap stocks that have grown dividends for at least 15 consecutive years, and the Russell 2000 Dividend Growth Index, a group of small-cap stocks that have grown dividends for at least 10 consecutive years, have delivered impressive upside/downside capture ratios since inception,” concludes ProShares.

Using the S&P MidCap 400 Dividend Aristocrats Index as an example, the index is beating its parent benchmark by nearly 1,000 basis points year-to-date. Perhaps that’s a sign to cease ignoring smaller stocks.

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