Small caps compelling despite, and because of, recent rough patch

10-16-2018

There’s no doubt U.S. small-cap stocks have had a rough go of late. They’ve fallen nearly 11% since the end of August, more than double the decline for large caps.1 But it’s not time to raise the white flag just yet; if anything, history suggest now may offer more compelling reasons to add to small-cap positions. Here are three:

  • Mean reversion. With September’s sell-off further widening large-caps’ outperformance versus small-caps over the past 5-year and 10-year periods, small caps arguably are in a better position to offer potentially better opportunities going forward. The reason is simply a matter of math. While nobody knows whether small caps or large caps will fare better from one calendar year to the next, historical research suggests after prolonged periods of outperformance by one group over the other, the laggard has tended to close the gap. Moreover, history also shows that over longer periods of time, small caps have tended to outpace large caps because they are riskier, and risk and returns tend to be commensurate over time.
  • Valuations. Indeed, the long-term average P/E ratio for small caps relative to large caps is 1.15—investors typically pay more for small caps because they offer more growth potential (a smart idea can quickly transform into something big: think Facebook) and more risk (without the resources of large company, a stumble can wipe out an entire company: think Pets.com). As of Sept. 30, the P/E ratio of small-cap to large-cap stocks was 1.0, signaling a 13% discount in favor of small caps, according to Morningstar Direct.
  • The cycle still has room to run. According to FTSE Russell, the average small-cap business cycle generates cumulative returns of 134% and lasts 750 trading days.2 While this cycle is getting a bit long in the tooth in terms of duration—it began in mid-February 2016—the cumulative returns are only 67%, putting the to-date return at only half that of a typical cycle. This indicates the current small-cap run could last longer and possibly result in even greater cumulative returns than average given the ramping up of growth under “Trumponomics,” whose tax cuts and regulatory relief have given the economy a second wind. One more thing to consider: if the trade war continues or escalates, small caps may be an effective hedge as they are more closely aligned with the domestic economy and thus somewhat immune to events outside U.S. borders.

Bottom line: we believe risk-oriented investors may want to consider adding to their U.S. small-cap positions.

1 Small caps represented by the Russell 2000 Index and large caps represented by the Russell 1000 Index.

2 A small-cap business cycle is measured from the bottom of a more-than-20% correction in the Russell 2000 Index to the next peak.