Sometimes, Smaller Is Just Better

Sometimes, Smaller Is Just Better
Paul Allison, CFA

about 1 year ago2 mins

Mentioned in story

A common narrative used to explain the fearsomeness of bear markets is that they’re a story told in two halves. The first sees a sharp valuation correction as markets start to anticipate tougher times ahead – that’s been 2022. The second is all about how tough those times actually get – that’ll be 2023.

And it’s an interesting narrative when you look at America’s smaller publicly traded companies. The chart shows the price-to-earnings (P/E) ratio for the S&P 600, an index of small-cap US firms. The ratio, commonly used to determine a stock’s valuation, is at levels seen only during the worst economic times, like the Covid crisis of March 2020 and the global financial crisis of 2008-09.

But there’s a plot twist: some major economic thinkers – Goldman Sachs is one of them – have recently started saying the US might avoid a recession completely. And if that happens, those US small-cap stocks, with their currently bleak-outlook valuations, would be poised to win big.

And it’s not just because those stocks might be undervalued. Small-cap firms tend to be domestically focused, with fewer dollars earned overseas. And in the current environment, that could be good for two reasons: 1) they’re likely to be sheltered from the seemingly unavoidable economic storm brewing in Europe and 2) they’re likely to be less impacted by weaker overseas profits resulting from US dollar strength.

Goldman could be wrong about the US economy, of course. But if you’re cozying up to the view that the US will scrape through without a recession, then its small caps could be an interesting opportunity. There are risks associated with investing in smaller firms, sure, but most of these – like liquidity risk or poor corporate governance – are minimized if you opt for an exchange-traded fund like the iShares S&P SmallCap 600 ETF (ticker: ISP6 LN TER; expense ratio: 0.4%), which is highly diversified with its top ten holdings representing less than 5% of the total fund.



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