Small-cap stocks, or companies with a market capitalization of less than $1 billion, are presumed to provide higher returns at a comparatively higher risk than large-cap stocks. However, market performance does not always satisfy such economic theories. For instance, over the last five years, the S&P 500 Index, which consists of well-known, large-cap stocks, outperformed the Russell 2000 Index.
Performance in the last five years
Source: Index price data.
In the long term, however, things could change as small companies can grow at much faster rates than their larger peers, garnering the attention of investors. This has historically been the case, as illustrated in the graph below, which plots the performance of the two indexes since 1980.
Peter Lynch, one of the most successful fund managers of all time, attributed his success to identifying small companies that many investors were not paying attention to. In his book, "One up on Wall Street," he made the case for investing in these companies:
"Look for small companies that are already profitable and have proven that their concept can be replicated. Big companies have small moves. Small companies have big moves."
There are multiple reasons to believe that 2020 will likely be a year in which small-cap stocks outperform their large-cap peers.
The underperformance in the last five years is nothing to worry about; it's history repeating itself
Small-cap stocks not delivering the expected returns in the recent past has led to skepticism about the overall market performance in the future as these companies play an important role in the global economy by boosting the disposable income of business owners. However, going by historical data, it's incorrect to assume that a rally in these stocks is far off. During bull markets dating back to the 1930s, small-cap stocks have trailed behind the broad market.
Source: Strategas Research Partners.
As depicted in the graph above, this phenomenon reversed when the S&P 500 Index traded sideways. The Federal Reserve projects the American economy will grow below 2% over the next couple of years, which suggests slower growth in comparison to the last three years. However, the most recent dot plot released in September points to rate hikes beyond 2020, indicating that the Fed does not fear a recession for at least another three years. Slow and steady economic growth is not the ideal setup for large companies to beat their earnings guidance, but small companies would be relatively unaffected by the state of the economy as these companies have ample opportunities to grow because of their size.
The declining interest rate environment will be helpful
When the Fed decides to cut rates to provide a boost to the economic growth of the country, many investors believe it will lead to a positive performance from equity markets. While historical data provokes debate around this belief, small-cap stocks have always provided better returns in such an environment.
In each of the periods analyzed by Jefferies analysts, small-cap stocks outperformed their large and medium-cap peers, which provides an insight into what might occur in 2020. One of the primary reasons behind thies phenomenon is the heavy reliance of small companies on the housing industry.
Steven DeSanctis, an equity strategist at Jefferies, confirmed this in a statement made in October:
"Lower rates are boosting housing and that's a very large portion of small-cap earnings and more so than large-caps. More than 30% of small-cap earnings come from housing, whereas only 12% of earnings in large-cap stocks come from the housing sector."
The next Fed meeting is scheduled for Dec. 11, and according to CME Group's Fedwatch tool, there's a 99% probability of rates remaining unchanged.
Source: CME Group.
However, the three rate cuts so far this year would be sufficient to trigger a rally in the shares of small companies in 2020.
The impact of the trade war
Trade tensions between the U.S. and China, the two largest economies in the world, have weighed down on both the American and Asian markets throughout the last one and half years. Even though both parties are working toward reaching some middle ground, a trade deal is yet to be announced. The fear and uncertainty resulting from the escalation of the trade dispute have pushed many investors to remain on the sidelines. However, it's important to note that mostly multinational organizations listed in the U.S. would feel the repercussions of these tensions - not every American company. Companies that depend on Chinese labor or consumers are at the highest risk.
According to data from the South China Morning Post and S&P Global Market Intelligence, the following companies are the most vulnerable to this negative development:
Market capitalization as of Dec. 8
General Motors (NYSE:GM)
Source: South China Morning Post, S&P and company filings.
All the companies in the above table have market capitalizations that run into the multibillion-dollar range, which is the same with many other companies that are projected to feel the heat of the trade war. Smaller companies generally operate within the U.S. and are not dependent on Chinese consumers or suppliers, which makes these companies a better bet in 2020, especially considering the geopolitical risks.
Valuation is cheap from a relative perspective
The S&P 600 Index is another popular benchmark used to evaluate the performance of small-cap stocks and usually trades at a much higher forward price-earnings ratio than the S&P 500 Index. This is because of the higher expected growth of these small companies. However, the gap between the two indexes has narrowed to record levels in the recent past.
Source: Yardeni Research.
According to data from Jefferies, when the valuation gap declines to these kinds of lows, small-cap stocks have outperformed large-caps by an average of 6% over the next 12 months. Jill Carey Hall, a senior U.S. equity strategist at Bank of America, confirmed this, saying:
"The relative P/E today suggests that small caps should lead large caps over the next decade."
The attractive performance of the S&P 600 Index in 2003 and 2014, when the valuation gap squeezed to historic lows, is another strong signal for investors to consider diversifying into shares of small companies.
On the back of a disappointing performance over the last five years, investors are beginning to doubt the ability of small companies to provide attractive returns. However, an analysis of macroeconomic developments, geopolitical tensions and historical performance data points to a stellar 2020 for small-cap stocks.
Value investors should especially look for bargains before these companies reach overvalued levels. There are several exchange-traded funds to choose from, including iShares Core S&P Small-Cap (IJR), Vanguard Small-cap Value (VBR), Vanguard Small-Cap Growth (VBK) and Invesco S&P Small-cap Low Volatility (XSLV). Investing directly in equity securities of companies requires thorough due diligence and analysis as the inherent risks are high, and I plan on analyzing a few companies on my watchlist and publishing these analyses on GuruFocus in the coming month.
Disclosure: I own Apple shares.
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This article first appeared on GuruFocus.