Wall St week ahead investors bet on 2nd wind for lagging US small caps

Some investors believe the stars are aligning for small-cap stocks, as the category stands to benefit from cheap valuations, robust economic growth and a relatively benign impact from looming tax policy changes.

About $2.4 billion has flowed into US small-cap equity funds so far this month, already the biggest monthly inflow since March, according to data provider EPFR. That had helped fuel an 8 per cent gain in the S&P 600 small-cap index as of earlier this week since late October, doubling the large-cap S&P 500’s performance in that period. The Russell 2000, a broader small-cap index, gained about 7 per cent over that time.

The small-cap indexes pared gains somewhat this week amid fears of a Covid-19 re-emergence.

Small caps, which have a median market capitalization of $1.2 billion in the Russell 2000, rallied in the early months of 2021 as investors bet that smaller firms would benefit more from a broad US economic reopening. They floundered in subsequent months, when technology stocks took the market’s reins amid worries over whether the Delta variant of the coronavirus would stifle the economic rebound. The Russell 2000 is up 19 per cent this year against a 25 per cent rise for the S&P 500.

With a blistering S&P 500 rally stretching valuations on large-cap stocks and above-trend US growth expected next year, some investors now believe small caps are a bargain.

The forward price-to-earnings ratio of the Russell 2000 compared to the large-cap Russell 1000 recently stood at 24 per cent below its long-term average, while small caps also trade at historical discounts on other measures such as price-to-book and price-to-sales, according to BofA Global Research.

“Smaller-cap stocks on a relative basis just look much more attractive,” said Ryan Jacob, chief investment officer of Jacob Asset Management.

His firm’s growth stock funds “probably have our highest weightings ever” in small-cap shares compared to large, Jacob said.

RBC strategists said the US economy is expected to expand 4 per cent next year, compared with its long-term average of 2.5 per cent, and believe small caps are a “pure play” on domestic growth. Analysts at BofA Global Research said the disparity in valuations between larger companies and smaller ones suggests high single-digit price returns annually for the Russell 2000 over the next decade compared with slightly negative annual returns for the S&P 500.

Chuck Carlson, chief executive officer at Horizon Investment Services in Hammond, Indiana, said his firm has added more small-cap exposure in the past four months, including shares of shipping company Matson and semiconductor firm Onto Innovation.

“After trading pretty much sideways for seven months, you had a pretty nice breakout,” Carlson said. “We like the fundamentals.”

The improving picture for smaller companies comes as a relief to investors looking for ways to diversify out of the megacap technology stocks that have led markets higher for most of the last decade, with the top five companies alone comprising more than 23 per cent weight in the S&P 500.