Three Reasons Small Stocks Have Big Potential

Three Reasons Small Stocks Have Big Potential
Milou Beunk

over 3 years ago3 mins

Mentioned in story

What’s going on here?

The very largest US stocks have dominated the recent market rally from lows reached in March – but Finimize analyst Milou thinks it might now be time for investors to shift into “small-caps” instead.

What does this mean?

Small-capitalization stocks, or small-caps, are typically those with a market value between $250 million and $2 billion. The pros of investing in small-caps include:

Higher growth potential: their lower starting point means they can grow at a rate larger companies can’t

Large institutional investors often avoid them: big investors would have to buy a large proportion of a small-cap’s shares to make an impact on their overall portfolio – so smaller players can get ahead of the game

Analyst coverage is limited: meaning stocks could potentially be undervalued.

The cons of small-caps include:

Higher risk: smaller customer bases and fewer financial buffers could mean businesses can go bust quicker when times turn bad

Volatility: trading volumes don’t have to be huge to move share prices significantly.

Small-caps typically underperform the broader stock market during downturns because their cash reserves are smaller and their revenues more sensitive to the state of the economy. But they also tend to bounce back faster: small-caps have in fact outperformed large-cap stocks nine of the past ten times the US economy was emerging from a downturn.

And that theory’s holding true this year. Small-caps underperformed during the stock market crash in March, but have since been regaining lost ground. As the European economic recovery looks more fragile than that in the US, we’re focusing on American small-caps (as measured by the Russell 2000 index) and large-caps (as measured by the Russell 1000).

Small-cap vs large-cap performance in 2020
Source: FactSet, Goldman Sachs Investment Research

Why should I care?

There are three reasons investments in small-cap companies should generate you higher returns than those in large-cap companies.

1️⃣ Outperformance could last for three years

History suggests that small-caps’ superior post-recession performance is far from fleeting. Research from investment manager Invesco shows that small-caps outperform by 7% on average over the subsequent year – and by an annual average of 3% across the three years following economic recovery.

Small-cap and large-cap returns post recessions
Source: NBER, FactSet, Invesco

2️⃣ Small-caps look cheap

Analysts have revised up their 2021 profit estimates for small-cap stocks by more than 30 percentage points – while large-cap estimates have only increased by two. Research from investment bank Goldman Sachs, meanwhile, suggests that small-cap valuations relative to large-caps are currently at historic lows.

Small-cap vs large-cap valuation compared to history
Source: Compustat, FactSet, IBES, Goldman Sachs

3️⃣ Small-caps outperform after elections

Small-caps also tend to outperform following US presidential elections – regardless of which side wins. Going back to 1980, small-caps’ average return in post-election years is 15% – compared to 11% for large-cap stocks, according to Citibank research. One reason small companies do well is the typical post-election focus on domestic US issues; with smaller companies more exposed to the local economy, this benefits them disproportionately.

Nevertheless, there’s a big caveat to the above: the present pandemic could yet derail any economic recovery – and as pointed out, large-caps do better in a recession than small-caps…

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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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