Small-Caps Getting Too Tempting To Ignore

November’s early stages have brought some relief to wary equity investors, but in broad terms, the past three months have been hard on stocks.

Not surprisingly, recent equity market weakness has been even more punitive for smaller stocks. For the three months ending Nov. 6, the large-cap S&P 500 declined 3.2%, but the average loss notched over that span by the Russell 2000 and S&P SmallCap 600 indexes was nearly triple that of the large-cap gauge. Year-to-date, those gauges are up an average of just 1% while the S&P 500 is higher by almost 15%. In other words, smaller stocks have hardly been worth the trouble.

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.

Clearly, the aforementioned performances of the major small-cap indexes belies potential benefits attributable to the strong dollar. That’s disappointing, but there’s reason to believe small-caps could be in for better things to close this year and into 2024.

Small-Caps Are Absurdly Cheap

Advisors know that valuation alone isn’t a reason to buy or sell a stock. Both cheap and richly valued stocks can remain in such states for lengthy periods of time.

However, the current valuation scenario with small-caps may be too compelling to ignore. Depending upon the forecast, the current valuation gap between small- and large-cap stocks is as wide as it’s been in decades or perhaps ever. Point is the asset class is really inexpensive right now and that could be indicative of opportunity.

“Today, stocks in the (Morningstar US) Small Cap Index carry an average price/fair value estimate ratio of 0.78, while the average stock in the Morningstar US Large Cap Index has a ratio of 0.93,” according to Morningstar. “This means stocks in the small-cap index are relatively cheaper than their larger counterparts. Ratios over 1.00 indicate a stock is overvalued, while ratios below 1.00 mean it’s undervalued. The further away from 1.00, the more over- or undervalued the asset.”

Still, data indicate professional investors aren’t yet taking the bait on small-caps – a point advisors should mention to clients.

“A net 18% of respondents in Bank of America’s most recent fund manager survey said they expect large caps to beat small caps over the next year,” adds Morningstar.

Another Reason to Consider Small-Caps

Indeed, advisors and clients should not ignore the fact that professional money managers aren’t scampering into small-caps at the moment. However, pros don’t bat .1000 and there other reasons to consider small stocks.

Notably, the aforementioned depressed valuations apply to profitable small-caps – a compelling point when considering such firms are hard to come by and when noting indexes such as the Russell 2000 are often heavily allocated to money-losing companies.

While small-caps may not immediately rally, it usually pays off to embrace discounted quality fare.

Related: There’s Still Hope for ESG, Sustainable Investing