Small stocks have big potential for the coming year.
They have already shaken off a seven-month funk and risen to record highs in November. Going forward, they have several ingredients in their favor. They are cheap in an expensive market, have attractive fundamentals, and can avoid several of the potential pitfalls facing large-caps in 2022.
Investors should consider a bigger allocation to smaller stocks in their portfolios. But take note: Not all small-caps, or small-cap indexes, are created equal.
The two main small-cap indexes are the Russell 2000 and the S&P SmallCap 600. Both are up about 6% this month.
The S&P 600, which includes a narrower slice of the small-cap universe than the Russell 2000, goes for less than 17 times expected earnings over the next 12 months, versus about 22 times for the S&P 500. The indexes were at roughly the same valuations in March, and historically small-caps have commanded a premium multiple.
“Small-caps were cheap relative to large-caps before trading sideways for seven months,” says Keith Lerner, co-chief investment officer at Truist Advisory Services, who upgraded small-caps to the equivalent of a Buy last month. “They’ve gotten even cheaper, as their forward earnings estimates have risen more strongly than the S&P 500.
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The S&P 600’s current multiple is in line with its historical average this century. In a market where most things are trading well above their average, something that trades close to its historical average is all the more attractive. It’s a strong starting point.
“The historical relationship between valuation and subsequent returns suggests small-caps should lead large-caps over the next decade, and points to slightly negative annualized price returns for the S&P 500 but high-single digit annualized price returns for the Russell 2000,” Bank of America Securities’ head of U.S. small- and mid-cap strategy Jill Carey Hall recently wrote.
There are a number of exchange-traded funds that track those indexes. The iShares Core S&P Small-Cap (ticker: IJR) is a $76 billion ETF with an expense ratio of just 0.06%. It is the best option for most investors looking to add a small-cap allocation to their portfolios. The iShares Russell 2000 ETF (IWM) is a similar size, but it has a 0.19% expense ratio and tracks a less-attractive index.
Unlike the Russell 2000, the S&P 600 index requires companies to have four consecutive quarters whose sum of earnings is positive, and is a better choice for next year. Many profit-challenged companies need to rely on debt to stay afloat—making them vulnerable to higher interest rates.
More broadly, however, small-caps can stand out if long-term interest rates rise more than short-term rates over the coming year, steepening the yield curve.
That’s because the small-cap indexes have more of a value tilt, compared with the S&P 500’s megacap, long-duration growth stocks.
More than 40% of the S&P 500’s market cap is in the technology and consumer-discretionary sectors—home to most of the stocks whose pricey valuations are at the greatest risk from higher rates.
By contrast, the S&P 600 has just a quarter of its market value in tech and consumer discretionary, and about 45% combined in financials, industrials, materials, and energy—20 percentage points more than the S&P 500.
There are other points in favor of small-caps over large in the coming months and year. The wrangling in Washington over corporate tax changes is far from over, and final details remain elusive as of now. But a proposal from Democrats that looks likely to stick is a 15% minimum tax for companies that report earnings of at least $1 billion in a year. Based on results over the past year, that would affect just one company in the S&P 600, Genworth Financial (GNW), while dozens of S&P 500 companies could see their tax bills rise next year.
U.S. mergers-and-acquisitions activity has been robust this year, and corporate balance sheets—not to mention acquisitive private-equity firms—remain flush with cash.
As relatively digestible takeover targets, small-caps would benefit from the continuation of that trend—either by being acquired themselves or by seeing their valuations rise when competitors are taken out.
Companies with higher returns and profit margins, to be sure, can better control their own fate, no matter what happens to interest rates and the economy next year.
Wells Fargo’s head of equity strategy, Christopher Harvey, looks to such quality small-cap stocks, which he defines as those with low net debt to earnings before interest, taxes, depreciation, and amortization, or Ebitda; high returns on equity or invested capital; and wide net-profit margins. He sees a “historic opportunity” in this group.
“You’ve got oversold conditions and cheap valuations counterbalanced by a challenging macro environment,” Harvey says. “But within small-caps, we think quality is the most mispriced factor in U.S. capital markets today.”
Historically, the average stock in the S&P SmallCap 600 Quality Index, which includes the top quintile of stocks in the broader small-cap index—Harvey’s quality group—trades at a significant premium to lower-quality small-caps. Today, it does not.
Even in a slowing economy, higher quality companies should be more stable and better able to maintain their profits. And with lower debt loads or net cash on their balance sheets, the expected rise in interest rates and widening of credit spreads won’t be as much of a threat.
All of that could earn those companies a valuation premium in the coming year. And should markets become more meaningfully volatile than they have been, stocks with quality factors should hold up better.
In an upgrade on Nov. 9, Harvey called out several small-cap stocks with quality attributes that are also Buy-rated by Wells Fargo equity analysts. They include Tegna (TGNA), National Vision Holdings (EYE), Magnolia Oil & Gas (MGY), PacWest Bancorp (PACW), Ionis Pharmaceuticals (IONS), MSC Industrial Direct (MSM), and CommVault Systems (CVLT). All have manageable debt loads, above-average returns on equity, and wide forecast profit margins.
Another way to get exposure to quality small-caps is the Invesco S&P SmallCap Quality ETF (XSHQ), which includes the 120 stocks in its namesake index. But the fund has less than $50 million in assets and a net expense ratio of 0.29%.
Market technicians also see plenty to like from small-caps. After trading sideways for seven months, the indexes have risen above their narrow trading range in the past two weeks. The Russell 2000 set its first record-high close since March on Nov. 2, and has continued rising since.
It has been a broad rally: Nearly 70% of the more than 1,700 stocks in Ned Davis Research’s small-cap universe are trading above their 50-day moving averages, which, before this week, hasn’t been the case since March. Ed Clissold, the firm’s chief U.S. strategist, upgraded small-caps over large-caps this past week, from neutral previously.
In addition, small-caps are entering their best period of the year.
“Small-cap relative strength came right on schedule,” Clissold wrote on Nov. 9. “Small-caps have consistently outperformed large-caps from November through February.”
The “chart looks good” thinking aside, Clissold sees some macro risks to his small-cap outperformance call. Historically, small-caps have done best relative to large-caps in the first third of an economic expansion, and trailed during the remainder.
Small-caps also lagged behind large-caps during the Federal Reserve’s last tapering cycle, from January to October 2014.
That history makes Harvey’s call on quality all the more timely.
Small-caps have risen from a monthslong slumber. Investors should expect more big things from these small stocks in the months to come.
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Write to Nicholas Jasinski at [email protected]
