Despite outperforming their large-cap peers over longer time periods, small- and mid-cap stocks have suffered a recent stretch of underperformance. As a result of this large-cap dominance over several years, many investors are likely under-allocated to smaller capitalization stocks. This year’s market drawdowns can be an opportunity for market participants to reconsider and potentially reset or fine-tune their portfolio asset allocations—signs point to a potential rebound for smaller capitalization stocks.
Smaller-cap stocks are in the bargain bin
Investors might be hard pressed to find any silver linings amidst the wreckage of the current market downturn. High levels of inflation, tightening monetary policy, and the ongoing conflict abroad are a potent combination that has left investor sentiment understandably in the dumps. But despite the dour mood, improving valuations are becoming hard to ignore.
While recent price weakness has left large-cap valuation metrics below their recent three-year averages, small- and mid-cap stocks offer an even more compelling value. Relative to large caps, price-to-book ratios for smaller stocks are trading at roughly half of large caps.
While it’s difficult to predict exactly when the valuation gap may begin to close, one potential catalyst could be continued earnings strength. As shown, analysts expect both small and mid-caps to deliver better earnings than large caps in the year ahead.
Of course, it’s important to note some potential variables in these forecasts. For one, small-cap stocks generally have thinner analyst coverage, so earnings estimates tend to be more volatile. And if the economy slips into a recession, the earnings picture could change materially. Nonetheless, current forecasts for the remainder of the year project robust growth.
Smaller-cap stocks have historically performed well during rising rates
Many have blamed a hawkish Fed and a more than 200 basis points [1] increase in 10-year Treasury yields since January for recent equity market weakness. Indeed, the long-term relationship between stocks and rates is mixed. But stocks have performed well during prior rising rate environments, especially during more recent periods.
In the past, there’s typically been a perception that companies with smaller market capitalizations are more leveraged than large caps and may face difficulties servicing their debt as rates rise. However, performance hasn’t always followed that narrative. Small- and mid-cap stocks have, in fact, outperformed large caps during the vast majority of recent rising rate environments.
Smaller cap stocks also get more of their revenues from within the US compared to larger cap stocks, and thus smaller cap stocks may be less susceptible to revenue volatility stemming from international turmoil.
Dividend growers have better-weathered market turbulence
When markets are volatile, many investors seek refuge in strategies with a history of weathering market turbulence. One formula for investors seeking outperformance can be fleeing to quality when markets are volatile.
Companies that Âhave continuously grown their dividends over time are typically seen as high quality with stable earnings, solid fundamentals, and strong histories of profit and growth. While often thought of as exclusively large-cap household names, dividend growers are also found among small- and mid-cap stocks.
The Russell Midcap Dividend Growth Index and the Russell 2000 Dividend Growth Index—a group of mid-and small-cap stocks, respectively, that have grown dividends for at least 10 consecutive years—have delivered lower risk and higher returns relative to their traditional counterparts over the past ten years. The Russell Top 200 Dividend Growth Index has had lower volatility compared to the Russell Top 200 Index, too, with similar levels of returns.
Shelter from the storm?
While large-cap stocks have enjoyed a good run relative to smaller-cap stocks, there are several signals that a reversal of fortune could be on the horizon. And investors seeking shelter from today’s market turbulence might find that high-quality small- and mid-cap dividend growth indexes are particularly well-positioned to weather the storm.
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[1] As of 9/30/22.
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Originally Posted October 21, 2022 – Are smaller-cap stocks due for a rebound?
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