Small-Cap Stocks Offering Value, Intriguing Potential

With the S&P 500 in a bear market, it’s not surprising clients would be skittish about small-cap stocks, but that’s why they have advisors because advisors can show them smaller stocks are performing less poorly than large rivals this year.

In fact, both the Russell 2000 and S&P SmallCap 600 indexes are outperforming the S&P 500 by decent margins in 2022. Alone, that’s an impressive data point, but one that’s even more so when considering small-cap benchmarks are often homes to significant amounts of stocks hailing from companies that aren’t profitable. As has been made abundantly clear over the course of 2022, this isn’t the market environment in which to get excited about low-quality companies.

Add to that, small-cap stocks are usually expensive on valuation, but even that’s falling by the wayside this year. 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.

Small-Cap Valuation Chasm Getting Real

Data confirm that, at least from a valuation perspective, now could be a good time for advisors to consider the small-cap conversation with clients.

“Historically, small-cap forward P/Es commanded about a 4% premium to large caps, though this relationship has steadily broken down in the last few years. After the summertime volatility, the forward P/E of the Russell 2000 relative to that of the large-cap-centric Russell 1000 remains more than two standard deviations below its long-term average,” notes WisdomTree’s Brian Manby.

Part of the reason for that valuation anomaly is that, as is currently the case with mid-caps, small-caps are getting the “recession punishment” treatment. Translation: Market participants expect a recession will weigh more heavily smaller stocks than large-caps.

That thesis isn’t unreasonable. However, markets are forward looking indicators and US GDP already slumped two consecutive quarters – the definition of a recession – and small-cap indexes are still outpacing the S&P 500.

Of Course, The Fed Matters

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.

Plus, history bodes well for smaller stocks because the asset class has a track record of performing well following examples of Fed-induced recessions – the type that’s likely to happen if an earnest recession materializes.

“Over the past two decades, small-cap valuations have breached a 20% discount to their long-term average forward P/E on nine occasions (using monthly data). For eight of these nine observations, small caps subsequently outperformed large caps over a two-year period by roughly 5% on average,” concludes Manby.

The point: 2022 isn’t “perfect” for any asset class, but the opportunity set available with small-caps is historically attractive and that’s worth acknowledging.

Related: TIPS Turned Terrible In 2022