Small-cap stocks may finally have their day in the sun

Small-cap stocks have underperformed large-caps for the last 10 years, and during much of that period many analysts have said a reversal is coming. So far it hasn’t happened.

But Bank of America says it may finally happen now, though only in a mild way. Part of the bullish case is that small-cap stocks have a cheap valuation compared to large-cap stocks, BofA equity strategist Jill Carey Hall wrote in commentary. The S&P 600 index of small-caps has a forward price-earnings ratio of 15, compared to 23 for the S&P 500.

There’s also the historical argument. Small-cap has outperformed large-cap over the long term. “And relative performance cycles suggest we’re due after a decade of small-cap underperformance,” she said.

Since 1925, small caps have posted annualized total returns of 15% with annualized volatility of 32%,  according to the Center for Research in Security Prices. For large-caps, it’s 12% returns with 20% volatility.

But small-cap bears point out that companies are staying private longer, that lower-quality companies represent a growing portion of initial public offerings and that fewer small-cap companies sport high growth than in the past.

Splitting the difference

So who’s right, the bulls or the bears? “The answer likely lies in between,” Hall said. “The marked valuation gap plus multi-year themes (peak globalization, reshoring, and capital expenditures) should support small vs. large over the next decade.”

But shifts in the Russell 2000 index of small-cap stocks and the S&P 500 suggest caution, she said. The Russell 2000 has shifted to lower quality and heavily indebted companies, while the S&P 500 has done the opposite.

“This suggests that the mean reversion potential of multiples and thus the magnitude of outperformance [by small-cap stocks] may be narrower than history suggests,” Hall said.

Those of you who are interested in small-cap stocks may wonder how to choose among them. “Investors are often attracted to small-caps for their growth potential,” Hall wrote. “But high projected long-term growth has been a poor stock-selection factor over time.”  

Value stocks have performed the best since 1989, with quality stocks (those with strong earnings) second. The best way to pick small-cap stocks long-term has been buying stocks with high free cash flow to enterprise value, Hall said.