What Are Small-Cap Stocks And Should You Invest In Them?

The U.S. stock market appears to be at a key inflection point. Optimism surrounding potential fed interest rate cuts in September is battling recession fears. Adding to the mix is the upcoming U.S. presidential elections, which with its twists and turns is starting to resemble a soap opera. For the most part, investors are ignoring the steady drumbeat of election noise, but market volatility seems to be the prevailing theme. Last week had its worst upheavals as the Dow Jones Industrial Average started the week by diving 1000 points and the S&P 500 fell 3% on a single day, representing a 10% decline from recent highs, while the Nasdaq Composite lost 13% from its 52-week highs. This raised concerns of the higher-for-longer interest rate environment introducing threats to the economy. However, market experts realized that unwinding of yen trades by hedge funds had caused the turmoil. The benchmark indices have made a nice recovery erasing the losses as the week ended. Amid the wild swings in market sentiment, experts see a comeback in small-cap stocks dubbed as the “great rotation,” as these stocks trade at a steeply discounted relative valuation vs. large-caps and stand to benefit most from an interest rate cut. This begs a few crucial questions like:

• Is this a good time to invest in stocks, especially small-caps that are typically more volatile than large-caps?
• Why invest in small-caps?
• What are the metrics to look for before investing in small-cap stocks?

What Are Small-Cap Stocks?

The general definition of a small-cap is a stock with a market cap between $300 million and $2 billion. The small-cap segment typically has less liquidity and potentially less financial stability than large-caps (which have market caps above $10 billion). The Russell 2000 index, which is considered the home for small-cap stocks, tracks the performance of 1,978 or nearly 2,000 small-cap US stocks. The average market capitalization of the Russell 2000 is $3.4 billion and the median market cap is $996 million (as of July 31). The S&P 600 small-cap index, which tracks 602 small-sized U.S. companies (as of July 31) is more selective in its criteria for including small-caps. For inclusion, stocks should have an unadjusted market cap between $1.0 billion and $6.7 billion and must have positive (as-reported) earnings for the most recent quarter, as well as for the most recent four quarters (summed together). The S&P 600 has a mean market cap of $2.4 billion and median market cap of $2.1 billion.

How Do The S&P Small Cap 600 And Russell 2000 Compare?

The Russell 2000 is the broader and more comprehensive index of the small-cap stock universe, but the S&P Small Cap 600 consistently beats the Russell 2000. This superior performance is attributed to the diligent construction of the S&P 600 index that has more stringent requirements for member inclusion.

The S&P 600 screens for companies with positive earnings, which gives it a qualitative edge over the Russell 2000, which has no such criteria.

Russell 2000 reconstitutes the index annually (except in the case of IPOs), and this may be too long a duration for small-cap stocks that are highly volatile. The S&P 600 is more flexible and reconstitutes the index on an as-needed basis, quickly reflecting market conditions, thereby perceived as more timely and accurate. This makes the S&P 600 index returns more stable vs. the Russell 2000.

Why Invest In Small-Cap Stocks?

Small Caps’ July Outperformance Vs. S&P 500 Sparks “Great Rotation” Enthusiasm

The Russell 2000 index rose 11% in July, while the S&P Small Cap 600 rose 12%. In comparison, the S&P 500 index edged up less than 1%. This outperformance of the small-caps indices, which is attributed to hopes of Fed rate cuts starting in September, caught the eye of investors, sparking enthusiasm about the “great rotation,” which in the current context refers to a rotation out of mega cap tech stocks with blistering valuations into small-cap stocks.

Why Are Fed Rate Cuts Critical To Small-Cap Stocks?

Logically, a Fed rate cut should favor large-cap stocks as well, so why the excitement around small-caps in particular? This is because small-caps typically have a larger debt burden and more floating-rate debt, thereby more exposed to higher interest rates. So, Fed rate cuts leading to lower borrowing costs are more impactful for smaller companies that tend to rely heavily on debt to fund operations and are highly sensitive to interest rates vs. large-caps.

Yet another corollary is the better performance of small-caps vs. large-caps in a lower interest rate environment. The Russell 2000–the benchmark for the U.S. Small cap stocks–has typically performed well in the past when the Fed policy shifts to interest rate cuts from rate hikes. Over the five Fed rate-cutting cycles since 1990, on average the Russell 2000 has outperformed the S&P 500 by 700 basis points in a 12-month period following the rate cuts.

Compelling Valuation

Besides Fed rate cut hopes, the compelling valuation of small-cap stocks is a major factor in the great rotation theory. The S&P Small Cap 600 trades at a forward P/E of 16.2x vs. S&P 500’s 21.4x. The Russell 2000 trades at a steep discount to the S&P 500. The relative valuation lingers close to a 37-year low, offering a compelling opportunity. When the valuation spread in the past was huge as the present one, the Russell 2000 had returned almost 40% on average in the following 12 months, according to a research by investment advisory firm Fidelity.

Characteristics of Small-Cap Stocks

While the “small stocks-big gains” concept is quite alluring with the much-touted high-growth potential for small-caps, there are no guarantees, especially since small-cap stocks are typically characterized by higher volatility, lesser liquidity and lesser financial stability vs. large-cap stocks.

High risk/reward potential

Investing in small-caps can pave the way for huge gains for investors, but the risks of failure can be equally high. Limited access to funding renders the small-caps highly susceptible to market fluctuations.

Lesser liquidity

Most small-cap stocks fly under the radar of investors with low trading volume, meaning reduced availability of buyers and sellers. This can impact buying and selling of such stocks leading to lesser liquidity, implying that it can seriously restrict your ability to make well-timed buys or sells.

Muted Earnings Growth

Small-caps are typically less profitable with huge debt burdens vs. large-caps that can navigate a challenging high-interest rate environment because of strong earnings growth and pricing power. About 43% of the companies in the Russell 2000 were categorized as loss-making as of June’s end. The Russell 2000 saw a decline of 12.1% in earnings for 2023, but forecasts indicate a potential rebound with a projected 13.4% earnings growth in 2024. This is notably higher than the 10.7% growth expected for the Russell 1000, which tracks large-cap stocks. Meanwhile, the S&P 600 is anticipated to achieve a remarkable 21% year-over-year earnings growth in the fourth quarter of 2024. The lack of any notable catalysts beyond rate cut expectations casts doubts on the feasibility of these ambitious earnings growth forecasts amid slowing economic growth and the fact that the Fed will ease interest rates only gradually.

Cheap does not necessarily translate to value

It’s true that small-caps trade at multi-year low valuations vs. large-caps. However, if weak fundamentals persist and earnings growth fails to meet rosy projections, what was perceived as value could easily turn into a value trap. A discounted valuation alone will not make the case for investing in small-caps, unless the fundamentals recover and grow robustly as projected. Investors looking for growth beyond large-cap techs can still find opportunities in the mid-cap and undervalued large-cap segments that are less-risky investments and equally well positioned as rotation beneficiaries.

That said, small-cap stocks offer significant growth potential. A well-rounded portfolio should include small-cap stocks as well, but it’s crucial to select the right ones and allocate funds based on your individual risk tolerance.

How To Research Small-Cap Stocks

It can be a daunting task to find information on small-cap stocks as many do not have adequate coverage from analysts or financial news/research websites. But, once you identify some stocks, the SEC filings could be a top source of information. Here are some general guidelines.

1. Keep up with the stock market news. You can also start by studying the S&P 600 companies. I prefer the S&P 600 to Russell 2000, because of its stringent qualifications for index inclusion.
2. Keep an eye out for emerging trends, technologies and trading patterns and check out companies that align with these trends.
3. Search for publicly traded companies that can offer unique, differentiated solutions and research its suppliers and other agents that can equally benefit from the success of the company.
4. It is best to avoid small-cap stocks that have an average trading volume of less than 250,000 shares in the last three months and less than $500 million in market cap.
5. Ensure that the small-cap company caters to a large, growing and quantifiable market. Even if the company has a smaller share in a huge market, it can lead to decent gains.
6. Research the company’s financials for at least the last three years to see if it is financially stable and consistently profitable. Metrics like revenue/sales, operating profit/margins, net profits, earnings per share, debt, cash can offer key insights into the growth outlook and financial well being of the company.
7. Check out the credentials of the company’s leadership. The top management’s past achievements and track record should provide some valuable guidance.
8. Take a close look at the risk factors in the company’s SEC filings. Company presentations/press releases can weave a colorful story, but filings cannot.
9. Look for red flags like sudden departure of top deck management, accounting issues, any pending SEC investigation, lawsuits, and other issues. These may not be necessarily bad but definitely warrant a deeper dig-in before you assign your hard-earned money to these risky securities.
10. It may be best to avoid companies struggling under a huge debt load with interest payments cutting into profits deeply. Check if the company has enough cash and access to credit facilities, check the cash burn, and debt maturities coming up in the near term. The company may engage in a stock offering to pay off the upcoming debt, and this will lead to dilution for shareholders. While this is not unusual, it is definitely not lauded either.
11. It would be a bonus if small-caps are aligned with shareholders via buybacks and dividends, implying strong free cash flow characteristics.

Investment Strategies For Small-Cap Stocks

Investors can invest in small-cap stocks directly or via funds (index funds, exchange-traded funds or mutual funds). Directly investing in small-caps can expose an investor to company-specific risks. If the investor has the skill and time to analyze small cap stocks, investing directly may be the best way to go as it has the potential for higher returns. But for the average investor, investing in small-caps via funds will be a better choice. Then comes up the choice of active or passive managed funds.

For an actively managed fund, a professional fund manager will choose and manage the investments to beat market returns, while a passive fund like an index fund or ETF attempts to replicate returns of a benchmark index (in this case the S&P 600 Small cap Index or the Russell 2000 index) and holds the same securities as that of the index in the same proportion. Returns from a passive fund are aligned with market returns. No surprise there.

With respect to small-cap stocks, actively managed funds have typically beaten passive funds because the volatile nature of small caps require more portfolio intervention. That said, index funds have a cost and tax advantage over active counterparts.

Actively managed funds charge a higher management fee to cover the fund manager’s services, as well as operational expenses, which is reflected in the expense ratio—expressed as a percentage of the fund’s assets under management (AUM). In contrast, passive funds typically have a lower expense ratio since they don’t require active fund management nor do these incur high transaction costs.

Market experts recommend that investors hold small caps for at least 10 years to benefit and allocate 8% of the portfolio to small caps. But this is entirely subject to the risk appetite and investment goals of the investor.

Bottom Line

The outlook for small-cap stocks looks increasingly optimistic, driven by anticipated Federal Reserve rate cuts, appealing valuations compared to large-caps and enthusiasm for the Great Rotation. However, sluggish earnings growth still remains a concern for the small-cap segment. Despite forecasts for a significant earnings rebound this year and into 2025, the absence of notable catalysts to support these predictions creates uncertainties. Risk averse investors, at the cost of missing out on any potential gains, may consider avoiding or limiting exposure to small-caps, focusing instead on mid caps or undervalued large-caps, which offer more stability and lesser risk. Small-cap stocks are more suitable for growth investors with a robust risk appetite.

Please note that I am not a registered investment advisor and readers should do their own due diligence before investing in this or any other stock. I am not responsible for the investment decisions made by individuals after reading this article. Readers are asked not to rely on the opinions and analysis expressed in the article and encouraged to do their own research before investing.

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