Why You Might Want To Bet On The Little Guys

Mega-cap tech stocks have a way of hogging the spotlight – and that’s certainly been the case in the recent rally. But right now, you might consider keeping an eye on the understated small-cap stocks. See, they could be ready to steal the show, and you might be able to cash in on their big moment.

What’s the appeal of small-cap stocks?

The big structural trends are set to bend in their direction.

Corporate giants have had seemingly everything going for them in recent years, and they’ve seen their growth explode with the rise of globalization and a long run of ultralow interest rates. But lately the tide’s been turning. More and more, manufacturing is being “reshored”, or returned to the company’s original country, and sputtering economies are expected to prompt a new burst of government stimulus. And those two forces tend to benefit small-cap stocks, which typically operate in “old economy” sectors like industrials, healthcare, real estate, and finance.

These old school sectors are usually less fazed by interest rate changes, compared to the more trendy sectors like tech. With those OG sectors, you don’t need to sweat about discounting distant future cash flows, after all. Plus, they’re primed to benefit from any uptick in capital spending, especially if it’s Uncle Sam opening his wallet.

Since they have a stronger domestic focus, these smaller firms are also well-positioned to reap the rewards of reshoring, as business activities are pulled back from overseas. And remember, it’s usually the big dogs that have the regulatory and tax targets on their backs, not these smaller contenders, so they’re less exposed to potential political fallout.

As for the possibility that inflation remains higher for longer, that too might play out in the favor of the smaller guys. They’re more accustomed to the cutthroat competition and leaner profit margins, so they’re often better equipped to weather the storm when inflation ramps up and puts the squeeze on profits.

Small-cap index Russell 2000 has different sector exposures than the S&P 500. Source: Bloomberg.

Their valuations already are attractive.

Small-cap stock valuations, measured by the adjusted forward price-to-earnings (P/E) ratio, have been on a downhill journey in recent years, landing at 13x. That’s an attractive 15% discount to their long-term average. But the bargains don't stop there: these littler stocks are also trading at about 30% less than their more burly, flashier counterparts (or even lower, depending on the valuation measure).

Small-cap stocks are extremely cheap, compared to big-cap ones. Source: Bank of America.

Sure, there are reasons they’re currently in the bargain bin: they’re more vulnerable to risk factors like regional banking stress, for one, and hiccups in the US economy, for another. But remember, while valuations might not be fortune tellers for short-term returns (those other factors have a much bigger say at a shorter horizon), they’re the MVPs when predicting returns over the long term (say, ten-plus years). The cheaper the starting valuations, the higher the long-term returns, almost independently of the drivers at the time.

So, investors who snap them up now and keep them close for the next decade could be looking at some pretty handsome rewards. In fact, current valuations suggest an 11% annual return over the next ten years for the Russell 2000 – that’s double the expected return of bigger-cap stocks. In a world where cash is now a serious investment, this shouldn’t count for nothing.

Small-cap stocks could outperform big-cap stocks by three to five percentage points over the next decade. Source: Bank of America.

And there’s an interesting risk-reward proposition at this stage of the business cycle.

While small-cap stocks might be more vulnerable to an economic downturn, there are reasons why they’re a compelling play right now. Unlike the big kids on the block, they’re trading at levels consistent with an ISM manufacturing index that’s down around 40 (far uglier than what we’ve got now), meaning they’ve already factored in a more severe recession. Plus, they’re offering a way more tempting “risk premium” (think: returns that make the risks worthwhile) compared to big caps, which are playing a high-stakes game with zero margin for error.

The equity risk premium is high for small caps, meaning that returns could be expected to adequately compensate for their risks. Source: Bank of America.

That means two things. First, while small caps would surely feel the burn if the economy suffers a crash-landing, their price already has a built-in safety buffer that could soften the blow. Second, if the economy manages a soft-landing scenario, small caps could see some hefty returns roll in.

In fact, small caps usually lag behind their large-cap peers more in the final growth phase of the economic cycle, rather than during a downturn. As we’re potentially nearing that downturn (or possibly the first phase of the cycle), the risk-reward balance could be looking pretty appealing right now.

Small caps’ relative underperformance is surprisingly muted in the downturn phase, and the outperformance is extremely strong in the early phase of the economic cycle. Source: Bank of America.

So what’s the opportunity then?

Don’t get me wrong, small-cap stocks are a risk-on asset and could see deep losses if the economy hurls itself into a heavy recession. And with a potential liquidity crunch, the debt ceiling drama, and some awfully nervous sentiment, these shares may be walking into a storm. So, if you can’t stomach the turbulence, you might want to steer clear.

That being said, I can see these stocks holding a lot of appeal for long-term investors, especially as a complement to more speculative tech stocks. Their valuations provide them with an attractive cushion, their returns might get an extra boost from changing structural trends, and they may be getting closer to an attractive price entry point. So, a good strategy might be to either enter opportunistically if prices drop sharply, or to buy gradually over the next few months (perhaps using dollar-cost averaging) to reduce the timing risk.

I also expect they could be a smart play in a mild – as opposed to a brutal – recession. Now, that kind of downturn isn’t my go-to prediction, but hey, it’s not off the table, either. Small-cap stocks also have their place in a more balanced portfolio, both as part of an overall stock exposure and as a counterweight to more defensive assets like gold and Treasury bonds.

As for what to buy, you’ve got a few options. The easiest one might be to buy a diversified US small-cap ETF like the Schwab US Small-Cap ETF (ticker: SCHA; expense ratio: 0.04%). It’s well-diversified and has a very low fee, and could be a solid long-term addition to your portfolio.

If you prefer to hold companies of slightly higher quality (and accept slightly less attractive valuations), then check out the Vanguard S&P Small-Cap 600 ETF (VIOO; 0.10%). If you also want a value-investing tilt, you might consider the Vanguard Small Cap Value ETF (VBR; 0.07%). But if you’re seeking higher potential returns above all else, the Avantis International Small Cap Value ETF (AVDV; 0.36%) might fit the bill. Just be aware that it’s arguably riskier and more expensive than the others.

Then again, if you’ve got a knack for picking individual winners – or if you just want to try your hand at picking them – I’d suggest starting by looking at high-quality small-caps stocks, with the following screen from Bank of America. It’s an impressive pool to draw from.

High quality small cap stocks. Source: Bank Of America