Small-capitalization stocks have been on a tear since February. After a long period of lagging performance, small-cap stocks stole center stage in the recent recovery in U.S. equities.
Some economists point to small caps as a barometer for the overall health of the U.S. economy. The leadership in this sector is seen as an encouraging sign for the market overall.
Analysts define market capitalization of a company — simply the stock price times the number of shares outstanding — in three categories. The first is small-cap stocks, which include companies in the $250 million to $2 billion range. Mid-cap stocks include companies in the $2 billion to $10 billion range, while large-cap stocks generally include companies with market capitalizations of $10 billion and greater.
[See: 11 Ways President Trump’s Tax Plan Could Affect Americans.]
Why do investors like small caps? “Small-cap stocks are seen as having stronger growth potential simply because they are small companies,” says Patrick O’Hare, chief market analyst at Briefing.com.
In the three-month period that ended May 31, the Russell 2000 index, the benchmark for small-cap stocks, gained 11.7 percent versus the Standard & Poor’s 500 index, which increased 8.5 percent, O’Hare says.
Stabilizing crude oil prices, dovish Federal Reserve comments, improving economic conditions and better-than-expected first-quarter earnings have helped bolster small-cap stock performance, says Terry Sandven, chief equity strategist at U.S. Bank Wealth Management in Minneapolis.
The resurgence of small-cap performance from the February lows is typically a positive omen for economic growth, Sandven says. “Small caps tend to outperform when the economy is expanding and the risk of a looming recession is low,” Sandven says.
The million-dollar question: Can the strength of the small-cap sector continue? The jury is still out, but there are some encouraging signs.
“For small caps to continue to outperform, the broad economy needs to improve, and revenue and earnings growth need to accelerate in the second half of 2016,” Sandven says. “The consumer seems well-positioned to drive economic growth. Wages are firming, consumer balance sheets have improved, home prices are up, consumer confidence is relatively high and the equivalent of a major tax cut in the form of lower energy prices has been received.”
Small-cap stocks are generally a domestic investment play. Investors looking to limit exposure to international risks and currency fluctuations may consider small caps.
[See: 11 Health Care ETFs for a Heart-Healthy Portfolio.]
“Almost all of their business is derived from the U.S.,” O’Hare says. “If you are an investor who wants to have a more directed approach to playing the U.S. economy versus the whole macro international economy, the small-cap sector is the way to go,” O’Hare says.
No matter your investing goals, small-cap stocks, with their strong growth potential, can play a key part in a diversified portfolio. “Having a nicely balanced portfolio that includes small caps is a prudent strategy for long-term investors,” O’Hare says.
Henry To, partner at CB Capital Partners, identified three top picks for investors to play the rising small-cap stock trend.
Schwab U.S. Small-Cap ETF (ticker: SCHA). The safest and most efficient way to play the U.S. small-cap stock trend is to purchase a low-cost index fund that gives you the broadest exposure, To says. He points to the Schwab U.S. Small-Cap ETF as an exchange-traded fund that fits the bill. It is the lowest-cost small-cap ETF available, with an annual expense ratio of just 0.08 percent.
“SCHA tracks the Dow Jones U.S. Small-Cap Total Stock Market index, which consists of the smallest 1,750 stocks out of the largest 2,500 publicly-traded U.S. stocks from a market capitalization perspective. It is diversified across sectors, industries and along the value-growth spectrum. SCHA also has decent liquidity, with a daily turnover of about $15 million, which is plentiful for those with a buy-and-hold strategy,” To says.
Vanguard Small-Cap Value ETF (VBR). This ETF offers a more opportunistic way to invest, as value stocks are likely to outperform over the next cycle, To says. “VBR’s portfolio contains around 800 holdings in the CRSP U.S. Small-Cap universe, which tracks U.S. publicly traded companies that are in the lowest 15 th percentile in terms of market capitalization, but excludes the bottom 2 percent. Its annual expense ratio of 0.09 percent is very low, which is a bonus,” To says.
DFA U.S. Small Fund (DFSTX). This fund is only offered through financial advisors. It has a slightly higher expense ratio at 0.37 percent relative to that of more passive funds. DFSTX has shown its value by outperforming both the small-cap indexes and its small-cap peers over time, excluding fees, To says.
[Read: BP Still Paying at the Pump.]
“DFA tracks the smallest 10 percent of the broad market. This means the average size of a constituent is smaller than that of other small-cap funds,” To says. “DFSTX is able to outperform its peers by opportunistically overweighting stocks with higher earnings quality, value characteristics and conducting the firm’s trading on its own platform. Because DFSTX is not tied to any one benchmark, the fund also does not need to purchase or sell stocks ahead of index changes, which also results in better performance.”
More from U.S. News
10 Ways to Invest in Pharmaceuticals With ETFs
8 Stocks to Buy For a Starter Portfolio
8 of the Most Incredible Investments of the 21st Century
Why Investors Should Consider Small-Cap Stocks originally appeared on usnews.com
