Even though small-cap stocks outperformed large caps in 2020, the companies in this sector are predicted to continue their upward trend.
The Russell 2000 (.RUT), a small-cap index, generated a 20% return in 2020. Small caps outperformed both large caps and midcaps – as the S&P 500 (.SPX) generated a 16.3% return, while the S&P MidCap 400 (.MGD) produced a 13.7% return.
Even though the bulk of the gain was in the last months of 2020, small-cap stocks should continue to generate higher returns this year.
"They have strong prospects going forward," says Genevieve Roch-Decter, CEO of Toronto-based Grit Capital, a financial media company, and a former portfolio manager of $100 million in assets for LDIC, a Canadian asset management firm. "I think there is more room to run."
Small-cap stocks outperformed on average in the months following the troughs of large-cap stocks during past recessions, says Jodie Gunzberg, managing director, chief institutional investment strategist at Morgan Stanley Wealth Management. In the six, 12 and 24 months following large-cap troughs, large caps gained 31.5%, 29.4% and 48.2% on average. However, the gains were larger with small caps that generated 46.9%, 53.4% and 86.2%, Gunzberg says.
A strong economic recovery would benefit small-cap stocks since small-cap and cyclical stocks are more sensitive to the economy, says Kristina Hooper, chief global market strategist at Invesco, an Atlanta-based investment company.
Small-cap stocks should outperform large-cap stocks in 2021 because of the potential for more fiscal stimulus and a strong economic recovery fueled by the vaccine in the second half of 2021, she says.
If you're interested in small-cap stocks, here are a few points to keep in mind:
- Factors that could boost small caps.
- Small caps provide diversification.
- How to invest in small-cap stocks.
Factors that could boost small caps
Small caps could contribute to a further run on small-cap names in the new year, says Mike Loewengart, managing director of investment strategy at E-Trade Financial, an Arlington, Virginia-based brokerage company.
"With behemoth tech companies reaping the benefits of the stay-at-home economy, some could argue that growth is already priced in," he says. "But as we work toward economic recovery, small caps may continue to see tailwinds – historically outperforming during bouts of economic acceleration. Further, any additional fiscal stimulus will likely move the needle more for small companies compared to their larger peers."
Inflation, rising interest rates and growth can help the performance of small-cap stocks, Gunzberg says.
"Small caps with exposure to pro-cyclical industries and more aggressive growth opportunities could benefit from recovery tailwinds, better earnings and resumption in the broader economy," she says. "Historically, recessions have driven change in leadership, and we don't see this cycle as being different, so as markets move toward employing an early cycle playbook, one might consider adding small caps."
There are about 13,000 small-cap companies with market capitalizations less than $2 billion in North America. They could continue to rise in value because of inflation and a large amount of capital available, Roch-Decter says. Another positive factor is that commodities perform well in a late-stage bull market, she adds.
"Small caps with leverage to rising copper and gold prices should do well," Roch-Decter says. "One of the ways to play is the TSX Composite in Canada since 50% is weighted to commodities."
Small caps could continue to perform well amid expectations for a strong U.S. economic recovery, says Jon Maier, chief investment officer of Global X ETFs, a New York-based provider of exchange-traded funds. Small businesses drive the economy. In 2019, the Small Business Administration reported they employed 47.3% of the private workforce.
"Small caps generally do well as economies recover," he says. "With good news on the vaccine front, there are expectations that economies will reopen and this will certainly benefit small caps."
Small-cap growth stocks have historically not been significantly impacted by interest rate levels over the long term, since they often have low debt levels and are driven more by their fundamental trajectories than interest rate levels, says Amy Zhang, a portfolio manager who manages small-cap and midcap stocks at Alger, a New York-based investment firm.
"We believe smaller-cap stocks benefit from faster growth, and we think 2021 will see faster growth than 2020 given additional government stimulus checks and increased reopenings across the U.S.," she says. "We believe economic growth in the country is accelerating, and small caps will be the beneficiaries."
Small caps provide diversification
Small caps are "fundamentally different than large-cap stocks since they have high growth potential and may be more nimble," Gunzberg says. In market-cap weighted indices, small caps will not have the concentration risk like large caps since there is an "upper bound on the size of the companies before they graduate to midcap," she says.
The Russell 2000 is a more cyclically exposed index and more responsive to economic trends since the benchmark consists of 15% to 16% in financial stocks compared to 10% in the S&P 500, which "would respond positively to a steepening of yield curve in an improving economy," says Michael Underhill, chief investment officer of Capital Innovations in Pewaukee, Wisconsin.
By composition, industrials are 15% of the Russell 2000 compared to 9% in the S&P 500. Consumer discretionary is 16% in the Russell 2000 versus 11% in the S&P 500. One notable factor is that the Russell 2000 is also underweight in the defensive sector, slow growth economy sectors such as telecommunication, consumer nondurables and high growth technology at 12% compared to nearly 28% in the S&P 500.
"They are a reliable diversifier for a portfolio given the more cyclical/value composition of the index versus other indices such as the S&P 500, Russell 1000 Growth and Nasdaq," Underhill says.
Small caps perform well with inflation, especially since their revenue is generated mostly from the U.S. and they are less likely to hedge against any natural resources they produce.
Small-cap stocks are impacted by how interest rates change – falling rate environments with the largest interest rate declines are challenging for equities regardless of size, but large caps fare better, Gunzberg says. When there are the largest interest rate declines, the average monthly return for the S&P 500 is a decline of 2.2%, while the Russell 2000 dips by 3.8% and the S&P MidCap 400 falls by 3.1%, she says.
How to invest in small-cap stocks
Over the long run, small stocks provide much higher returns than large stocks. From 1966 through 2018, small-cap stocks returned 12.8%, while large caps returned 10.1%, says Robert Johnson, a finance professor at Creighton University in Omaha, Nebraska.
The Russell 2000 is the most popular small-cap index and is composed of the smallest 2,000 stocks in the Russell 3000 Index (.RUA). However, the median market cap of the Russell 2000 as of June 2020 was $639 million, while the median market cap of the S&P SmallCap 600 is $1.5 billion.
Investors who want exposure to small caps can choose from several ETFs that are based on these two indexes: the iShares Russell 2000 ETF (IWM), the Vanguard Russell 2000 ETF (VTWO), the iShares Core S&P Small-Cap ETF (IJR), the SPDR S&P 600 Small Cap ETF (SLY) and the Vanguard S&P Small-Cap 600 ETF (VIOO).
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