Why America’s Small Stocks Are (Still) Worth A Little Look

Why America’s Small Stocks Are (Still) Worth A Little Look
Milou Beunk

almost 3 years ago2 mins

What’s going on here?

Smaller US stocks have surged since I last wrote about them in November: the country’s key “small-cap” index is up 40%, twice as much as its large-cap cousin. Some say the rally’s now run its course – but I think smaller stocks still have plenty of room left to rise. Here’s why you may want to give them a little look.

Small-caps do better during economic recoveries

Economic growth is expected to be plentiful as the US bounces back from last year’s slump. Smaller firms’ prospects look particularly good: their earnings are typically more sensitive to the state of the economy than larger rivals’.

The small-cap Russell 2000 Index has a greater exposure to cyclical sectors like finance than the large-cap Russell 1000 (15% vs. 11%), as well as a smaller exposure to technology (12% vs. 27%). Financial firms benefit more from improving economic conditions than tech stocks, which tend to do well no matter what.

This greater cyclicality is what drives small-caps’ outperformance during economic recoveries. And those outsize gains generally last a while. Small-cap stocks have historically beaten large-caps by 7% in the year following an economic recession – and by an annual average of 3% over the three-year post-recession period. So small-caps could be in for further outperformance this time, too.

US small-cap vs. large cap index post-recession performance
US small-cap vs. large cap index post-recession performance (Source: NBER, FactSet, Invesco)

Small-cap stocks are still lagging large-cap stocks

Before flattening out in recent weeks, US small-cap stock prices were rising rapidly – but they still haven’t caught up with large-cap stocks. Small-caps are currently sitting 6% below their average position relative to large-cap prices over the past ten years.

US small-cap vs. large-cap index prices over the last decade
US small-cap vs. large-cap index prices over the last decade (Source: Bloomberg)

Prices alone aren’t that informative, however. You also need to compare the value of shares to companies’ profits and the value of their assets to determine whether they’re cheap or expensive.

Yet contrasting small- and large-cap stocks’ price-to-book ratios shows small-caps lagging even further behind. Their valuation is 12% lower than it’s typically been over the last decade compared to large-cap stocks’. Even a mere reversion to that long-term trend would mean a good deal of upside remains for small-cap stock prices.

Price-to-book ratios of US small-cap vs. large-cap indexes
Price-to-book ratios of US small-cap vs. large-cap indexes (Source: Bloomberg)

Why should I care?

Small-cap stocks historically do better than large-cap stocks for longer during economic recoveries – and they’re also much cheaper than usual right now. So despite their impressive outperformance over the past seven months, I think now is still a good time to switch part of your portfolio into smaller stocks.

The iShares Russell 2000 ETF is the largest exchange-traded fund for the key US small-cap index described above. This could be a good way to get cheap and diversified exposure to what I see as being a rather big opportunity in smaller stocks.

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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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