Small Stocks Might Finally Be Ready To Outmuscle Their Bigger Rivals

Small Stocks Might Finally Be Ready To Outmuscle Their Bigger Rivals
Carl Hazeley

about 2 years ago3 mins

  • In the last 12 months, small cap stocks have had their worst run versus large cap stocks since 1999.

  • There’s a lot going against small caps, namely the withdrawal of central bank support, slowing of economic growth, and the narrowing gap between short-term and long-term government bond yields.

  • But inflation’s still at a record high, which could be a good sign for small caps – particularly those expected to deliver high sales growth and profit margins.

In the last 12 months, small cap stocks have had their worst run versus large cap stocks since 1999.

There’s a lot going against small caps, namely the withdrawal of central bank support, slowing of economic growth, and the narrowing gap between short-term and long-term government bond yields.

But inflation’s still at a record high, which could be a good sign for small caps – particularly those expected to deliver high sales growth and profit margins.

Mentioned in story

The Russell 2000 – a key US small cap index – is down 7% compared to the large cap S&P 500’s 19% rise in the last twelve months, making it the worst relative performance since 1999. And frankly, the next twelve months don’t look much better. But one trend in particular – high inflation – is creating an environment that could give certain small caps the edge…

Why are US small caps underperforming?

There are two key reasons. First, the Russell 2000 has a higher weighting of cyclical companies than the S&P 500, which makes the index more sensitive to rising and falling economic growth expectations. Smaller companies, after all, have lower profit margins and smaller cash piles, while also being less competitive than bigger ones. So given that economic growth expectations have slowed down after 2021’s bumper recovery, smaller stocks have been hit harder than their larger rivals.

Second, the recent rise in US government bond yields in anticipation of interest rate hikes has made those bonds more attractive investments, while having the opposite effect on riskier stocks. And seeing as Russell 2000 companies are typically high-growth, low-profit (with a third of Russell 2000 companies expected to be loss-making this year), its stocks are by definition riskier and, in turn, more vulnerable.

What’s the outlook for US small caps?

Three things signal weakness ahead for small cap stocks this year: the withdrawal of central bank support, the slowdown in economic growth rates, and the narrowing of the gap between short-term government bond yields and long-term yields.

That’s because, over the last 20 years, small caps have on average underperformed large caps during periods when some (or all) of the above are either happening or expected to happen.

Russell 2000 historically underperforms S&P 500 in this environment.
Russell 2000 historically underperforms S&P 500 in this environment.

But historical data shows that in times of higher inflation, small cap stocks outperform their bigger rivals. When the inflation rate is above 5%, in fact, it's small stocks – not large caps or corporate bonds – that provide investors with the best chance of delivering inflation-beating returns.

Source: Ibbotson & Harrington, SBBI (2020), Fairlight Asset Management
Source: Ibbotson & Harrington, SBBI (2020), Fairlight Asset Management

And now might be a particularly good time to buy in: the Russell 2000 is as cheap relative to the S&P 500 as it’s been since early 2019.

Ratio of Russell 2000 EV/sales multiple to S&P 500.
Ratio of Russell 2000 EV/sales multiple to S&P 500.

So what’s the opportunity here?

Since the macroeconomic environment makes it both risky and attractive to buy into small caps now, Goldman Sachs reckons a smart way to play this is to focus on small cap stocks with a combination of strong sales growth, high profit margins, and attractive-looking valuations.

The bank specifically screened for Russell 2000 companies worth more than $1 billion, where analysts were expecting 2023 sales growth of above 10%, 2023 net income profit margins of above 10%, and below-average EV/sales multiples. Here’s a list of stocks that fall into that bracket:

GS screen

Casting the net wider, I was able to use the free online tool Finviz to replicate part of Goldman’s screen: I filtered for companies worth between $2 billion and $10 billion, with a five-year track record of over 10% annual sales growth, a price-to-sales ratio below 2, and a 10%-or-higher net income margin.

You can view the results, sorted by company size, here. Otherwise, the biggest companies are shown below.

Source: Finviz.
Source: Finviz.

That’s still a lot of names, so it may make sense to start with home construction company MDC Holdings and weight loss firm Medifast, since they show up on both Goldman’s screen and my Finviz one.

Finimize

BECOME A SMARTER INVESTOR

All the daily investing news and insights you need in one subscription.

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.

/3 Your free quarterly content is about to expire. Uncover the biggest trends and opportunities. Subscribe now for 50%. Cancel anytime.

Finimize
© Finimize Ltd. 2023. 10328011. 280 Bishopsgate, London, EC2M 4AG