In a year characterized by strong equity market performances, small-cap stocks have performed well below their potential. Larger peers have set new milestones for most of the year, with the S&P 500 up around 7% over the past year and 18.7% year to date. In contrast, the S&P SmallCap 600 Index is down 9.7% in the last one year and has gained only 12.3% year to date.
This runs against conventional logic, which suggests that over extended periods of time, smaller stocks outperform their larger counterparts. This advantage is popularly referred to as the premium of the “size factor.” The underperformance of small caps is likely attributable to worries about the economy.
Most analysts now believe that fears of a near-term recession are largely unfounded. This means small caps could easily catch up with their larger peers over the rest of 2019. Adding small-caps with strong year-to-date gains to your portfolio makes for a smart choice at this time.
Multiple Macro Factors Favor Small Caps
While presidents Trump and Xi have settled on a temporary truce for the time being, the U.S.-China trade war is far from over. Fundamental differences over state support to Chinese companies and concerns over intellectual property rights remain largely unresolved. Also, Trump is likely to dial up the protectionist rhetoric against other key trading partners, including European countries.
Small caps have a natural advantage under such circumstances. Since most of them have a domestic focus, they are largely insulated against trade tensions and the impact of escalating tariffs. Their domestic focus should also protect them from the adverse impact of a surging U.S. dollar, which has been trending higher since early 2018.
Fears of Economic Slowdown Overblown
If multiple factors are working in their favor, why have small caps underperformed their larger peers over an extended period? A likely culprit could be worries about economic weakness and a possible intensification of such deceleration in the near term. With their robust balance sheets and consistent earnings performances, large caps usually outperform their smaller peers under such circumstances.
Though economic expansion may have lost some of its momentum, experts think a near-term recession is highly unlikely. June’s strong jobs numbers proves that the labor market remains in fine fettle even so far into a record-busting period of economic growth. This means that small caps should catch up with their larger peers in the second half once such fears have been finally put to rest.
Despite the release of strong job numbers, market participants are continuing to hope for a series of rate cuts this year from a Federal Reserve which has likely softened its policy stance. Lower interest rates would greatly benefit smaller companies, by reducing their debt servicing burden significantly.
Small-cap stocks have underperformed their larger peers during the first half of the year. However, last week’s jobs numbers has dispelled most doubts about the domestic economy, a development which could greatly aid smaller companies. Their domestic focus also insulated them from the impact of trade tensions and a surging U.S. dollar.
Investing in small-cap stocks which have made strong gains year to date looks prudent. However, picking winning stocks may be difficult.
This is where our VGM Score comes in. Here V stands for Value, G for Growth and M for Momentum and the score is a weighted combination of these three scores. Such a score allows you to eliminate the negative aspects of stocks and select winners. However, it is important to keep in mind that each Style Score will carry a different weight while arriving at a VGM Score.
We have narrowed down our search to the following stocks, each of which has a Zacks Rank #1 (Strong Buy) and a VGM Score of A. You can see the complete list of today’s Zacks #1 Rank stocks here.
Xcel Brands, Inc. XELB operates as a brand management company in the United States.
Xcel Brands’ expected earnings growth for the current year is 33.3%. The stock has gained 91.2% year to date.
Construction Partners, Inc. ROAD is an infrastructure and road construction company.
Construction Partners’ Zacks Consensus Estimate for the current year has improved by 77.9% over the past 60 days. The stock has gained 65.7% year to date.
Earthstone Energy, Inc. ESTE develops and operates oil and gas properties in the United States.
Earthstone Energy’ Zacks Consensus Estimate for the current year has improved by 14.4% over the past 30 days. The stock has gained 46.9% year to date.
Oasis Midstream Partners LP OMP owns, develops, operate and acquires a diversified portfolio of midstream assets.
Oasis Midstream’s expected earnings growth for the current year is 79.1%. The Zacks Consensus Estimate for the current year has improved by 2.9% over the past 30 days. The stock has gained 39.5% year to date.
Hibbett Sports, Inc. HIBB is a major athletic-inspired retailer, located in small and mid-sized markets across the United States.
Hibbett Sports’ projected growth rate for the current year is 16.4%. The Zacks Consensus Estimate for the current year has improved by 0.2% over the last 30 days. The stock has gained 31.1% year to date.
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