Small-cap stocks have taken a beating in the past few days, in an abrupt turnaround from their extended rally. But this quite possibly is a chance for investors to scoop up small-caps ahead of a longer-term rebound.
The Russell 2000 has fallen almost 10% from its 2021 high hit just 10 days ago—putting it on pace to enter correction territory.
Small-capitalization stocks had been on an impressive run since September, when investors started moving into more economically-sensitive assets on hopes for an end to the pandemic and the reopening of the U.S. economy—plus trillions of dollars in fiscal stimulus. Economic downturns are a bigger threat to the stability of smaller firms, since they don’t have the same access to capital that larger companies enjoy. And with many small-cap companies focused on the U.S. market, their earnings also tend to be more sensitive to changes in the domestic economic landscape.
In recent days, investors have been repositioning away from cyclical stocks after the group’s long winning streak, and small-caps have been no exception. While it is anybody’s guess when this pullback will end, small-cap stocks are looking increasingly attractive to some analysts as a result.
“We prefer small-caps for the year as a whole, would ride out any short-term underperformance,” Lori Calvasina, chief U.S. equity strategist of RBC Capital Markets, wrote in a Wednesday note.
Currently, the average market value for the Russell 1000 index—which consists of large and smaller capitalization stocks—is about $39 billion. That’s 23 times as large as the average market cap on the Russell 2000, according to RBC data. That metric’s historical average, dating back to 2000, is 21 times. The wider gap between the average market cap suggests that small-caps have more outperformance versus large-caps ahead, especially as they ride earnings momentum from a U.S. economic recovery.
The Russell 2000’s technical indicators also point to strength ahead for smaller names. The index dipped below its 50-day moving average on Tuesday, and it “has seen many of its best rallies start after such an occurrence,” wrote Frank Cappelleri, chief market technician at Instinet in a note.
Within small-caps, value stocks might be the best subset for buying the dip. Value-oriented companies are typically more mature companies, so their earnings can be more sensitive to changes in the economy than those of fast-growing companies capitalizing on new industry trends.
Oil producer Diamondback Energy (ticker: FANG), which has a market capitalization of $13 billion, is a good example of the opportunity in small-cap value. Its shares have fallen about 15% from the 2021 high hit earlier this month. The stock trades at 9 times forward earnings, a steep discount to the Russell 2000 Value index’s 21.5 times.
Diamondback stock has been about a third more volatile than the broader market, according to FactSet. That means any gains for larger value names could translate to even more upside to smaller value names like Diamondback. That’s especially true if the price of crude oil can get back to $65 a barrel from the current level of $60. In addition, the company’s earnings are expected to more than double this year, and are forecast to grow almost 30% in 2022, according to FactSet. The stock, however, barely reflects such the earnings momentum ahead: It still trades at less than half the forward earnings multiple it has averaged in the past five years.
In order for the broader group of small-cap stocks to regain momentum, however, their valuations have to be tolerable, too. The latest pullback should help with that.
In addition, RBC’s Calvasina points out that these stocks already remain “deeply compelling” from a valuation perspective when compared with S&P 500 stocks.
“That valuation recovery is still in the early innings of a recovery off lows last seen in the tech bubble,” she writes.
Write to Jacob Sonenshine at [email protected]
