It's Not Too Late to Invest in Small-Cap Stocks

The Russell 2000 index is at a record high but still has room to run

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Nov 29, 2020
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Small-cap stocks are expected to outperform large-cap stocks in the long run because smaller companies can grow their earnings at a comparatively faster pace than their more mature peers. For this reason, it's natural to assume that investors would be willing to pay a premium to buy stocks of small companies that are in good financial shape.

The market performance over the last decade, however, has deviated considerably from these expectations, and the largest tech companies in the world, such as Facebook, Inc. (FB, Financial), Apple, Inc. (AAPL, Financial) and Alphabet Inc. (GOOG, Financial), dominated the decade-long bull run that lasted until the beginning of this year.

In the recovery phase of the market that began in late-March, small-cap stocks have bounced back strongly, giving a glimpse of what the future holds for this asset class in the coming years. In my opinion, small-cap stocks still have room left to run on recent stimulus.

The Russell 2000 index, which is one of the most popular benchmarks to track the performance of small-cap stocks, hit an all-time high in November, and this month is likely to go down in the history books as the best calendar month for the index since its inception in 1984:

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Source: CNBC

The outlook is promising

Despite this rally, I think both value and growth investors can still find many attractive opportunities in unpopular and unloved publicly listed small companies.

The overall strength and health of an economy will play an important role in determining which asset classes deliver the best returns. A research paper published by the North American Journal of Economics and Finance in 2011 argues that large-cap stocks tend to outperform the broad market during the lead up to an economic peak. During recessions, however, there is no conclusive evidence to suggest which asset class performs the best. Arguably, the best time to invest in small-cap stocks is during young bull markets that form during an economic growth revival of a country. There are many reasons behind this conclusion.

First, the ultra-low interest rate environment is a blessing for many American companies that would otherwise face difficulties in servicing high costs of debt. Young companies tend to hold their capital investment plans until favorable funding options are available, which is exactly the case today. For this reason, many small companies can be expected to roll out their investment plans by securing funds at record low rates. This will boost the expected earnings of these companies and will likely result in an expansion in valuation multiples as well when the general investing public reacts to this phenomenon.

Second, the ability of small organizations to react to the changing macroeconomic environment at a faster pace than their larger peers will give them an edge in the recovery phase as companies of every scale and size are required to adhere to newly implemented preventive measures introduced by health authorities. For a large company, it would take months to fully implement all these measures and it would turn out to be a costly affair as well. On the flip side, changing their business models to adapt to the new reality would be relatively easier for smaller companies.

Third, many small companies derive the bulk of their revenue domestically, which could be a game-changer if the American economy recovers as expected in 2021. According to Nathan Moser, the portfolio manager of the Pax World Small Cap Fund, S&P 500 companies generate just 40% of their revenue from domestic sources whereas the number is as high as 80% for the Russell 2000 index. There are uncertainties surrounding international trade as many nations have sought to become self-sufficient during this recession to position themselves better to face future lockdowns and pandemics. If this trend continues, American companies relying on international revenue might find it difficult to achieve revenue growth objectives. On the other hand, such a trend would be a win for small companies. The market could react to this kind of development by pushing the Russell 2000 index to new highs in the coming years.

Fourth, empirical evidence suggests small caps will come back strongly during the early stages of a new business cycle. Data compiled by Royce Invest reveals it has taken 11.7 months on average for small-cap stocks to recover from a trough since 1945, and from recovery to the new peak, the reported mean return is close to 56%.

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Source: Royce Invest

If history repeats, investors in small caps are in for a nice ride in the coming months.

Taking many of these developments and expectations into consideration, Ned Davis Research believes now is the best time to invest in the equity securities of small American companies. In a note to clients, the firm wrote:

"Given our view that we are in the early stages of the business cycle and a new bull market, we point out that small-cap stocks historically have performed well relative to their large-cap counterparts coming out of recessions. The story is the same coming off a major bear market lows where, on average, small caps have outperformed large caps by about 15% during the first year of bull markets."

Many Wall Street analysts are beginning to notice the lucrative opportunities available in this space. Speaking to CNBC, small and mid-cap equity strategist at Jefferies, Steven DeSanctis, said:

"The overall macro backdrop is just getting better. With people feeling a little bit better about prospects for 2021, you want to own the laggards, that's small-cap. You want to own stuff that's tethered to economic growth, that's going to be small-cap."

Carefully analyzing this space would be helpful in identifying companies that could deliver multi-bagger returns in the coming years.

Takeaway

Small-cap stocks are finally making a strong comeback, and this might just be the beginning. According to many Wall Street analysts, now is the time to find undervalued small companies. Empirical evidence supports this thesis as well.

That being said, it's important to minimize the risks associated with high growth companies. To do this, the best way forward would be to strike a balance between small and large companies in a portfolio and to invest in several industries and business sectors as opposed to concentrating on just a few market segments.

An easy way to achieve this objective is to invest in an exchange-traded fund that focuses on small-cap stocks. A best-in-class option is the iShares Russell 2000 ETF (IWM, Financial). The fund currently owns 2,017 stocks according to its latest fact sheet, and its top 10 holdings represent less than 4% of the total portfolio, which is a clear indication of the diversification benefits associated with this fund. The top holdings are illustrated below:

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Source: iShares

Tactical asset allocation decisions play an important role in helping an investor beat the market, and the macroeconomic outlook suggests investing in small-cap stocks could lead to lucrative returns in the foreseeable future.

Disclosure: The author is long Facebook.

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