Small Stocks Have Found Themselves In A Perfect Position

Small Stocks Have Found Themselves In A Perfect Position
Milou Beunk

almost 3 years ago3 mins

With expensive stock valuations and fears of inflation abounding, there’s one perfect investment that both offers you protection from sudden price rises and sits at its cheapest relative valuation in a decade.

What’s the opportunity here?

I’ve made the case before that small stocks tend to perform well during an economic recovery, but historical data shows they’re a great choice in an inflationary environment too.

In the below graph, you can see that large-cap stocks and small-cap stocks have broadly similar inflation-beating characteristics in a “normal” environment. But when inflation really kicks in and goes above 5%, it's small stocks – more than large caps or corporate bonds – that provide investors with the greatest chance of delivering inflation-beating returns.

Frequency of US annual returns outpacing inflation.
Source: Ibbotson & Harrington, SBBI (2020), Fairlight Asset Management

That stands to reason: lots of small companies operate in niche markets, and they’re able to grow their earnings because of the favorable demand-supply conditions in their own industries. That leaves them relatively insulated from macroeconomic pressures.

And they’re cheap?

Small-caps stocks have outperformed their larger peers in the US by 12% since news of the vaccines broke, and if you look at their high aggregate price-to-earnings (P/E) ratio compared to large-cap stocks, you’d be forgiven for thinking they're not cheap at all.

P/E ratio differential: small-cap minus large-cap
Source: Leuthold Group

But you need to dig a little deeper to get at the real story here.

See, the number of money-losing companies is abnormally high these days. And since a rise in unprofitable companies lowers the “earnings” part of the price-to-earnings ratio, the ratio itself increases.

But here’s the thing: money-losing companies tend to either be those that were previously profitable but suffering a cyclical downturn, or young startups that haven’t reached profitability yet. The recent increase in unprofitable companies can probably be explained by both factors: small companies’ profitability took a battering from the pandemic, while investors have only become more interested in backing startups. In other words, the high p/e ratio – and apparent expensiveness – is more down to surrounding factors than to the companies themselves.

So if you correct for this by calculating the P/E ratios excluding money-losing companies, it turns out that profitable small-cap stocks across most regions are actually trading at their largest discounts to large-cap stocks in the last decade. The same is true if you look at other valuation metrics, like price-to-cash flow (P/CF) and enterprise-value-to-EBITDA (EV/EBITDA) ratios.

P/E ratio (ex unprofitable companies) differential: small-cap minus large-cap
Source: Leuthold Group

So what’s the best way to invest?

The rule of thumb when it comes to small caps is diversification, diversification, diversification.

Small-cap stocks, after all, are both more volatile than large caps – and more likely to fail. That makes investing through an exchange-traded fund (ETF) that tracks a broad regional index of small-cap stocks a good option. So if you want to invest in the US, the biggest ETF for small caps is the iShares Core S&P Small-Cap (ticker: IJR). And in Europe the biggest is the Xtrackers MSCI Europe Small Cap ETF (ticker: XXSC).

Key takeaways

  • Small stocks have historically offered much better protection against inflation than large-cap stocks or bonds.
  • Don’t be put off by high p/e valuations either: they’re probably down a pandemic slump, or because the firm’s a startup that’s not quite there yet
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Disclaimer: These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment advisor.

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