about 2 months ago • 2 mins
Sometimes the small can be mighty – but that wasn’t the case for stocks in 2023. US small-cap stocks (represented here by the Russell 2000 index) returned 15% last year – far short of the 23% returned by their more muscular brothers in the S&P 500 – hit harder by interest rate hikes, a mini banking crisis in certain regions, recession worries, and an AI boom that fueled a strapping rally for the huge-cap Magnificent Seven.
Things could be different now, though: small-cap shares look fighting fit and ready for a better year. Here’s why.
First, small-caps are vastly under-owned. These companies, typically valued between $300 million and $2 billion, currently make up only 4% of the overall US stock market, about half the long-term average of almost 8%. It’s been this low only twice before, in March 2020 and during the 1930s. Big Tech’s dominance has played a role here, hogging the spotlight in 2023. And that means there’s a ton of room for small shares to gain as investors rebalance their assets and look to diversify.
Second, the big picture is likely to turn in favor of the Russell 2000 companies: these firms carry more debt and have a higher proportion of floating rate debt compared to their S&P 500 counterparts. And, sure, that’s meant they suffered more damage from the impact of rising interest rates, but now with the Federal Reserve likely to cut rates, they’re likely to see more benefit.
Third, small-cap firms could see a boost from the reshoring trend, which is bringing manufacturing operations back to the US because of geopolitical and supply chain risks, diminishing cost advantages, and other factors. Small-cap US stocks stand to gain more from this movement because more of their business comes from home, rather than abroad. For companies in the Russell 2000, roughly 90% of revenue comes from the US, compared to 60% to 65% for those in the S&P 500.
And fourth, small-caps look good on a valuation basis, trading at almost 20% below their long-term average, while their heftier counterparts are cruising at up to 20% above their usual. This difference is especially wide right now, and history tells us we’re probably headed for a significant turnaround.
But, before you dive full-boar into the small-cap pool, here’s a heads-up: about 40% of the Russell 2000’s companies didn’t make a profit last year. So, you’re going to need to look for the diamonds in the rough, essentially stocks with quality earnings. If you want to dip your toes in, check out options like the Pacer US Small Cap Cash Cows 100 ETF (ticker: CALF; expense ratio: 0.59%) or the Invesco S&P Small Cap Quality ETF (XSHQ; 0.3%).
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.