Small-Cap Stocks Appear Ready For Big Things

Small-Cap Stocks Appear Ready For Big Things
Luke Suddards

about 1 year ago2 mins

Small-cap stocks have been lifted by the market’s general rising tide, but that’s left investors facing a really important question: where to next?

The Russell 2000’s forward price-to-earnings (P/E) ratio rose to 13.8 this month (where the red arrow is pointing), from 12.4 last month. But that still leaves it 10% below its long-term average.

And the stars could be aligning for small caps as they’ve got some really attractive traits for these unique economic circumstances. Small-cap stocks are more geared toward services than goods (67% of their earnings, versus 52% for large caps) and services demand is holding up better than goods. Plus, small-cap companies tend to benefit when capital expenditures across the economy grow (in fact, those conditions have an 85% correlation with small-cap sales growth). And with many firms signaling a desire to move their manufacturing facilities closer to home, small caps would benefit from the capital expenditure growth that’s likely to result. They’re also more insulated from the profit squeeze many large-cap companies are seeing as sticky costs like wages remain high.

Small-cap companies have actually outperformed their large-cap peers for at least 70 years, including during the late 1970s and early 1980s, an era of high inflation and rising interest rates. Much like the current era. Small caps have tended to be more defensive than larger ones in times like these. And that makes sense: they’re more likely to be boring companies with fairly certain cash flows, not the high-flying growth stocks whose cash flows come and go.

The chart above is the final piece of the puzzle. Data since 1985, analyzing the future 10-year annualized returns based on different forward price-earnings ratios, predicts that given today’s 13.8 P/E ratio, we are likely to see a 10% annualized return over the next decade for the Russell 2000. If this appeals to you and you’re prepared to hold the investment over that time horizon, you might consider buying the iShares Russell 2000 ETF (ticker: IWM; expense ratio: 0.19%).

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