There’s always a reason to examine tiny caps, but now might be an especially appealing time to do so. Small caps are benefiting from economic factors and good relative prices as the post-pandemic recovery continues.
In the years following a recession, small caps have historically outperformed their larger brethren. This is attributable to, among other things, small caps’ more locally oriented exposure and higher operational leverage. Consider the early 2000s dot-com bubble. Small caps1 outpaced large caps2 by 42 percent in the three years after the bear market. Following the global financial crisis of 2008, a similar tendency emerged (GFC). Small caps outperformed large caps by 32% in the three years following the GFC.
While past performance is no guarantee of future results, the 2020 pandemic-induced equity market decline is similar to these two prior bear markets. As the economic recovery from the Covid epidemic continues, small caps may be well positioned to deliver strong results. In fact, small-cap equities have outperformed their larger counterparts in the third quarter of this year.
Since the spring of 2021, small caps have trailed large caps as the market leadership has shifted away from cyclical, value-oriented segments and toward more growth-oriented segments. This shift was motivated, in part, by fears about the economy’s recovery as a result of inflation and supply-chain issues. Nonetheless, there’s reason to assume that the small-cap outperformance cycle isn’t over it’s simply taking a breather.
For one thing, more infrastructure spending is likely to benefit industries that are more heavily represented among small caps, such as industrials, energy, and utilities. Furthermore, corporations currently have large amounts of cash, which we believe will contribute to a rise in capital spending and merger and acquisition activity, both of which should favor smaller-cap stocks. Small caps are ideally positioned to potentially lead markets higher as inflation and supply-chain issues are resolved over time, allowing for more spending and investment.
Favorable small-cap valuations
While economic trends favor small caps, the asset class’s relative prices are also enticing. Small-cap stocks are currently trading at their widest discount to large-cap stocks in 20 years. The small-cap discount to large-cap indexes has widened in recent years, owing to the divergent sector compositions of the large- and small-cap indices in the United States.
The information technology (IT) sector, for example, has a much higher weighting in the S&P 500 Index, a growth category that has thrived in recent years. The Russell 2000 Index, on the other hand, has a bigger weight in the financials sector, a more value-oriented sector that has underperformed. Notably, after reaching a similar level of “cheapness” in early 2001, small-cap stocks beat large-cap stocks by a significant margin over the next three, five, and ten years. 3
Small cap and fixed income an unlikely couple
Increasing small-cap equity exposure alongside fixed income could help minimize the low-risk fixed-income investment’s negative impact on expected return.
Are small-cap stocks low-risk investments?
Investing in small-cap companies is riskier than investing in large-cap organizations. They have higher long-term growth potential and better returns than large-cap companies, but they lack the resources of large-cap corporations, leaving them more sensitive to negative occurrences and bearish views.
Should I invest in tiny or mid-cap companies?
- Market capitalization, or the entire worth of a company’s shares in the market, is frequently used to categorize publicly listed corporations.
- Large-cap companies, defined as those with a market capitalization of $10 billion or more, grow more slowly than small-cap companies, defined as those with a market capitalisation of $300 million to $2 billion.
- Large-cap firms are more mature, and as a result, they are less volatile during bear markets as investors seek safety and become more risk-averse.
What should I buy before the financial crisis?
During a recession, you might be tempted to sell all of your investments, but experts advise against doing so. When the rest of the economy is fragile, there are usually a few sectors that continue to grow and provide investors with consistent returns.
Consider investing in the healthcare, utilities, and consumer goods sectors if you wish to protect yourself in part with equities during a recession. Regardless of the health of the economy, people will continue to spend money on medical care, household items, electricity, and food. As a result, during busts, these stocks tend to fare well (and underperform during booms).
What is an example of a good recession stock to buy?
During a recession, a solid investing approach is to look for companies that are retaining strong balance sheets or stable business models despite the economic downturn. Utilities, basic consumer products conglomerates, and defense stocks are examples of these types of businesses. Investors frequently increase exposure to these groups in their portfolios in anticipation of declining economic conditions.
Are small caps worth the investment?
- Small-cap stocks have a higher growth potential than large-cap stocks, and small-cap value index funds outperform the S&P 500 over time.
- Small-cap stocks are also more volatile than large-cap stocks, and individual small businesses are more likely to go bankrupt.
- Small-cap stocks are best suited to investors who are willing to take on greater risk in exchange for a bigger potential return.
What percentage of my portfolio should be made up of small-cap stocks?
Small-cap equities tend to outperform large-cap stocks over time, so an investor with a 5- to 10-year investment horizon should feel comfortable putting 10% to 20% of their portfolio in small-cap stocks, according to Chan. As a result, he believes that having long-term exposure to (small caps) is a wise investment move.