FICS Editors' note

Small-cap stocks tend to be riskier and more volatile than large stocks. Do your research or consult an adviser before deciding if they're right for you.

A safer way to ride the small-cap stock rally

  • By Daren Fonda,
  • Barron's
  • Facebook.
  • Twitter.
  • LinkedIn.
  • Google Plus
  • Print

Small-cap stocks are on a roll this year, but anyone buying now may be wise to stick with higher-quality companies, or funds that invest in them.

While the Russell 2000 index (.RUT) of small-capitalization stocks is up about 13% so far in 2019, beating the 10% return of the Russell 1000 index (.RUI) of large-caps, investors may have grown complacent about the risks involved, according to Richard Turnill, global chief investment strategist for BlackRock.

Small-cap stocks are tightly correlated to swings in global purchasing managers index (PMI) data, he pointed out in a blog post. And small-caps have jumped this year without a corresponding improvement in global PMI figures—a sign that sales and profits may not rise enough to justify the higher stock prices.

Expectations that U.S. interest rates won't jump from recent levels have contributed to small-caps' gains. But that be wishful thinking, too.

The markets may be "under-appreciating the possibility that the Federal Reserve will raise rates later this year," Turnill writes. An increase in borrowing costs could disproportionately affect small companies because they tend to have higher operating leverage, or debt levels, than large companies in the same sectors.

Another cause for concern is that small companies issue more floating-rate debt, which is pegged to short-term rates, than large companies. And small-company debt usually isn't high-quality. More than half the debt issued by companies in the MSCI ACWI Small Cap index is rated below investment grade, or junk, Turnill notes.

Valuations for global small-caps do look reasonable, he adds. Forward price/earnings ratios are slightly below their five-year average, but reductions in analysts' forecasts for small-cap profits have exceeded those for large-cap companies over the last three months, he notes. And because small-caps have thinner profit margins and higher debt levels, they may be more susceptible to further downgrades, with the potential to weigh on stock prices, especially if rates inch up later in the year.

Turnill says that investors should stick with large-cap stocks for their "stronger balance sheets, more diverse businesses, and greater operational flexibility."

Rather than avoid small-caps altogether, however, we suggest maintaining exposure, with caution. One option is to use an exchange-traded fund that applies a quality tilt to small-caps, avoiding many of the junkier and riskier companies.

The Schwab Fundamental U.S. Small Company Index ETF (FNDA) holds small-caps with an average return on equity of 10%, versus 6% for the Russell 2000, according to Schwab. Stocks in the ETF have slightly lower P/E and price-to-book ratios, on average. The fund, with an expense ratio of 0.25%, is up 13.4% this year.

The WisdomTree U.S. SmallCap Earnings Fund (EES) weights small-cap stocks based on earnings, weeding out unprofitable firms. The ETF's calendar-year returns have beaten the average small-cap blend fund—holding both growth and value stocks—every year since 2016, according to Morningstar. It has returned an annualized 14.6% over the past three years. Its expense ratio is 0.38%.

The WisdomTree U.S. Small-Cap Quality Dividend Growth Fund (DGRS) adds a dividend overlay to measures that screen for quality. It holds 269 stocks screened for dividend income and profitability and is up 14.1% this year. The fund has a 30-day yield of 2.2% and an expense ratio of 0.38%.

  • Facebook.
  • Twitter.
  • LinkedIn.
  • Google Plus
  • Print

For more news you can use to help guide your financial life, visit our Insights page.


Unique source copyright in disclosure link below - remove this text
Votes are submitted voluntarily by individuals and reflect their own opinion of the article's helpfulness. A percentage value for helpfulness will display once a sufficient number of votes have been submitted.
close
Please enter a valid e-mail address
Please enter a valid e-mail address
Important legal information about the e-mail you will be sending. By using this service, you agree to input your real e-mail address and only send it to people you know. It is a violation of law in some jurisdictions to falsely identify yourself in an e-mail. All information you provide will be used by Fidelity solely for the purpose of sending the e-mail on your behalf.The subject line of the e-mail you send will be "Fidelity.com: "

Your e-mail has been sent.
close

Your e-mail has been sent.