Don't Give Up on Small-Cap Stocks

Time for Small-Cap Stocks in portfolio

A little over a year ago, I said that small-company stocks offered good value – they weren’t dead, as many believed.

Sure enough, they woke with a start. In less than six months – from Sept. 24, 2020, to March 15, 2021 – the small-capitalization S&P 600 Index rose an incredible 69%, more than triple the gain of the large-cap S&P 500.

Afterward, however, small caps reverted to the pattern that has prevailed since 2014. Their prices plateaued over the next six months, while large-company shares kept up a briskly consistent ascension. It’s not that small caps have done poorly over the past decade. Their returns are well into the double digits and are higher than historical averages. The problem is that in this bull market the little companies have trailed the big ones so badly that it makes you wonder whether the gap is permanent. Consider the Russell 2000, a popular small-cap index. Over the past five years, the large-cap Russell 1000 has beaten the Russell 2000 by an annual average of four percentage points and over the past 10 years by 2.6 points. These are serious differences – especially because, historically, small caps have solidly outperformed large caps.

To compensate for their greater risk, small caps have historically scored higher returns. Except that lately – despite that amazing six-month spurt – they haven’t. Since 2014, Vanguard Russell 1000 ( VONE ), an exchange-traded fund linked to the large-cap index, has beaten the Vanguard Russell 2000 ( VTWO ), an ETF that tracks its small-cap analog index, in seven of eight calendar years, including so far in 2021. (Stocks and funds I like are in bold.)

Has something profound and lasting happened to small caps, or is this period an anomaly that might be in the process of reverting to the mean?

The case for large caps begins with investors’ enormous enthusiasm for both S&P 500 Index funds and the stocks with trillion-dollar market values that dominate those funds. Another change that favors large caps is that as technology allows business to become more global, giant companies have a huge advantage, both in efficient supply chains and in marketing brands known throughout the world. Also, in this low-interest-rate environment, large firms can gain easier access to cheap money, so they can grow even larger.

This case makes sense, but I view investments through a different prism. In markets, investors shun groups of stocks until those shares become irresistible. Then they jump in, and prices rise. That was the phenomenon that powered small caps from September 2020 through March 2021, which proved that these stocks can still attract investors. Big Bargains

Small caps are offering undeniable value. According to Morningstar, the average price-earnings ratio for the Russell 2000 stocks that make up Vanguard’s ETF is just 16, compared with 22 for the stocks in the Vanguard Russell 1000 ETF . The average price-to-book value for the small-cap ETF is 2.2, compared with 4.0 for the large-cap fund. The Russell 2000 ETF ( IWM ) has lower valuations despite having higher long-term earnings growth. Small caps have other attractions, too. The S&P 500 has become almost an internet specialty fund, with the information technology and communication services sectors together accounting for 39% of the total index. Those high-tech sectors amount to only 16% of the small-cap S&P 600. The small-cap indexes have the long-term advantage of being broadly diversified.

Tech stocks, furthermore, are not the only ones that are soaring.

Take Crocs ( CROX ), a Colorado-based maker of clunky though trendy slip-on clogs. Recently, under imaginative management, the company has grown impressively, its shoes becoming especially popular with teenagers. When COVID hit, investors feared the worst, and the stock lost half of its value. But since March 2020, the share price has risen by a factor of nine. (Take that, Apple!) Despite its spectacular rise, Crocs still carries a reasonable P/E of 20, based on the consensus of analysts’ estimates of earnings for the year ahead.

Crocs has increased in value so much that, at nearly $9 billion, its capitalization no longer qualifies as small. The generally accepted limit for a small-cap stock is $2 billion, but that’s an old number and probably too low; I would update it to about $4 billion. Under the Radar

Because they are followed by fewer financial analysts, small-cap stocks can escape notice and become underpriced. That may be the case with Calavo Growers ( CVGW ), a marketer and distributer of avocados. Calavo’s stock, which is covered by only five analysts […]

source Don’t Give Up on Small-Cap Stocks

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