Eq: Small Caps
If there were ever a small cap sector overwhelmed by their larger cousins, it would be in technology. Small cap tech stocks are so overshadowed by FAANGs and the like that one would be forgiven for not even realizing they exist. However, they do, and they may very well be a good buy at the moment. The S&P 600 Small-Cap Technology currently trades at half the valuation of the S&P 500 Technology index, way down from its historical spread. What’s more, profit estimates are healthier too. Calling small cap stocks “mini-fangs”, Leuthold Group argues that “the mini-Fangs offer a significantly higher growth profile at a substantially lower valuation”.
FINSUM: A couple notes here. Firstly, the FAANGs aren’t even really “tech” stocks anymore after the sector realignment, so the valuation comparisons are not perfect. Secondly, what is the catalyst? Leuthold argues that if the economy does a little better than expected then higher inflation will boost tech stocks. That sounds flimsy.
Small caps socks are having a rough year relative to the S&P 500. The Russell 2000 is up 15%, but behind the 19% gain of large caps. However, one area of small caps is doing great—momentum small caps, which are ahead of even their large cap cousins. Funds like the Invesco DWA SmallCap Momentum (DWAS), are up 26% this year through Wednesday. The fund aims to match the performance of the best 10% of stocks in the Russell 2000. Speaking broadly on the performance, the head of research at Nasdaq Dorset Wright says “Momentum can thrive in a market where you have a wide range of dispersions, and that’s especially true in the small-cap space, where you can have a big difference between the best and worst performers”.
FINSUM: There is a quite a variance in performance and financial conditions of small cap companies, and given the prevailing environment, that is creating highly differential results, which is great for momentum funds.
On the one hand the market looks very healthy (new all-time highs every day), but if you look more deeply there are some signs of dysfunction that appear as though they may spill out into the biggest indexes. Demand for risk assets looks quite weak. Consider for instance that the Russell 2000 is hurting even as large caps rise. Similarly, junk bonds are not doing well despite the seeming risk-on environment. Both of those developments show that liquidity is lacking. “Small caps are more sensitive to liquidity issues, both good and bad”, says a market strategist.
FINSUM: The weakness is small caps and junk bonds shows that more investors are sitting on the sidelines right now, but that does not necessarily mean trouble more broadly.
There is no arguing it, small caps have had a rough year. While the S&P 500 is up 9.4% from a year ago, the SmallCap 600 is down 8.4%. The divergence has been surprising to many, as several macro trends appear favorable for small cap appreciation, such as the trade war. However, for small caps to really get wind in their sails, things needing to be looking up in the economy, which seems unlikely in the short term. Therefore, one of the best ways to bet on size in your portfolio is to buy a specialized fund like the iShares Edge MSCI USA Size Factor ETF, which holds stocks in inverse proportion to their size. The smaller the stock, the greater its weight in the fund, helping investors skew towards small stocks, but not totally away from larger ones. The fund has outperformed the S&P 500 this year.
FINSUM: This is a very specialized angle, but does make some sense. We agree with the assessment of small caps right now—the underlying economy is not favorable for small cap bullishness.
Yes, the market is at or near all-time highs. Yes, the Fed is dovish, which is mildly bullish for markets (or very bullish if the economy stays in decent shape). However, equities are sending some strong warning signals too. In particular, two sectors which often act as bellwethers are showing that the market may be headed for a decline. Both small caps and transportation stocks have been struggling, a development usually associated with a market headed south. The sectors have declined at a rapid pace, and relative to the S&P 500 as a whole, are at their weakest point since 2009.
FINSUM: This is a signal similar in nature to the yield curve inversion. Is it material or just an aberration? Anyone’s guess.
Small caps are an interesting consideration right now. Ever since Trump’s election, they have had a general stimulus behind them from the widespread ethos of protectionism. Now, though, that push looks bigger than ever because of the trade war, meaning small caps might have smooth sailing. The problem is that it is hard to find the best small caps because of a lack of coverage by analysts and a weak online presence by many of them. With that in mind, Barron’s has some suggestions for how find good investments in the area, including joining online small cap communities (like Equity.guru and Small Cap Discoveries) and leveraging online discovery tools, like TMX Matrix, CEO.ca, and VRify.
FINSUM: A lot of alpha can be found in small caps simply through hard work and research. It is one of the areas of the equity markets where EMH theory is truly crap and knowledge advantages predominate.