While small-cap stocks derive their earnings domestically, these companies are less impacted by a strong or weak dollar. Smaller-cap names are generally more geared toward their local economy, but with the “prospects of high reward in small caps comes high risk,” says Viraj Desai, senior manager of portfolio construction at TD Ameritrade. Small-cap stocks have historically been more volatile than their large-cap counterparts.
“Larger-cap names that garner more of their revenue from abroad might be more insulated from local economic shocks, but small caps tend to be geared to the success or decline of their local economy,” he says.
The S&P SmallCap 600 total return has a long-term correlation of 0.82 with the S&P 500 total return, based on monthly data from January 1994 to August 2020. It is high but can offer some diversification benefit in the context of equities, says Jodie Gunzberg, managing director, chief investment strategist at Morgan Stanley, Wealth Management Institutional.
Small caps could outperform in the long term for growth in retirement portfolios, especially if growth accelerates after the current recession, she says.
These stocks can hedge against inflation more effectively than large caps since larger companies hedge against fluctuations in prices of inputs more often, Gunzberg says.
“Inflation is a key factor in planning for preserving purchasing power to and through retirement in order to continue the same standard of living as in the working years,” she says.
Potential Drawbacks of Small-Cap Stocks
Small caps could lack the financial resources, product diversification and competitive strengths of larger companies.
“In addition, small caps may not trade as readily and be subject to higher volatility than larger, more established companies,” Gunzberg says.
The annualized volatility of the S&P 500 total return and S&P SmallCap 600 total return over the one-year to 10-year and from July 1995 to August 2020 is, respectively, 23% vs. 30.8% and 15.1% vs. 19.1%.
“This amounts to an extra 4% annualized volatility from small caps over large caps in the long run, 5.5% annualized over five years and 7.8% in the last year,” she says.
Depending on the index or portfolio manager, there can be a wide variation of quality, liquidity and capacity constraints that investors should consider, Gunzberg says.
If the economy deteriorates, small caps could face some challenges. Small caps have fared poorly during economic downturns and performed well during economic recoveries, Desai says.
“Just as small caps do best with accelerating growth, they suffer most with a slowdown,” she says. “It is not all bad news, though, because a lot of the stimulus is directly aimed at helping smaller companies through the global pandemic, so there is a cushion to soften the blow now.”
Any further deterioration in the economy could also allow more active opportunities for small-cap managers to take advantage of potentially higher volatility and “dispersion from a greater spread in winners and losers,” Gunzberg says.
The S&P SmallCap 600 is projected to grow earnings per share 107% in 2021, compared with the sub-30% gain anticipated for the S&P 500, says Sam Stovall, chief investment strategist at CFRA, a New York-based investment research company.
“Plus, the S&P SmallCap 600 currently trades at a 17% discount to its average relative price to earnings for the small-cap index compared to the price to earnings for the S&P 500,” he says.
Low interest rates should help propel small-cap prices, but if the U.S. economy does not undergo the “V-shaped” recovery expected by many economists, the small-cap recovery may again sputter, Stovall says.
Investors should only rotate out of some large caps, especially in retirement accounts, if their target weights are now off balance from the market moves.
“However, investors may use pullbacks in the market to enter small caps opportunistically, based on valuations, particularly if large-cap holdings are in passive large caps or large-cap growth where the concentration risk is currently very high,” Gunzberg says.
Small caps underperformed by 13.8% during Republican presidential terms but outperformed by 13.7% during Democratic presidential terms historically on average, she says.
“If history is any guide and Biden wins, perhaps it may be another tailwind for small caps over the next term,” Gunzberg says.
Small caps can potentially generate above-market earnings growth rates since it takes less to move the needle for a smaller business relative to their large-cap peers, says Mike Loewengart, managing director, investment strategy at E-Trade Financial.
“We’ve certainly seen the market do a 180 since March, which could provide tailwinds for small caps as we look ahead, and attractive valuations could appeal to risk-on investors,” he says. “Small caps can experience exaggerated price swings during a volatile market compared to large-cap names.”
Given the volatility of small caps, investors should be “mindful that a little bit can go a long way,” Desai says. “Owning too much small-cap exposure potentially exposes investors to outsized risk, he says. “Maintaining the lion’s share of stocks in larger capitalizations but venturing out in little bits into small caps allows for some potential lift above and beyond what large caps alone may provide.”
Investors who are seeking passive exposure can add an exchange-traded fund benchmarked to the Russell 2000 index since it provides broad exposure to the entire U.S. small-cap market.
“An ETF would be one cost-effective way of gaining broad exposure to the market without putting a lot of effort,” Desai says.
Since there are 2,000 stocks in small caps, there is the potential that many of them could offset stronger performers in a material way, so investors may want to consider an active mutual fund with a “track record of identifying opportunities,” he says.
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