There’s “conventional wisdom” out there that as a bull market matures, large cap stocks tend to become the outperformers. According to this thinking, investors tend to shift investments to companies with well-established revenue sources, market penetration, and huge stockpiles of cash as a bull market ages. In theory, and for the most part in practice, these are the companies better suited to weather an economic downturn.
This means that small caps tend to get slighted in the late stages of a bull, but I think there are some circumstances in the current environment that argue for the opposite. Indeed, I see some good reasons now to bulk-up on small caps in context of a diversified approach.
3 Reasons You Might Want to Bump-Up Your Small Cap Allocation…
When we start working with new clients at Zacks, we tend to notice that folks are under-allocated with small cap stocks. Often, the response we hear is that small caps are “too risky and volatile.” While this is true, relative to large caps, it is far less true when you factor in the potential long-term growth benefit. In that sense, it is arguably riskier not to own small caps.
A look at the last 15 years provides a good example for what I mean here. From 2000 – 2014, small caps (using the Russell 2000 Index) as a category have annualized +7.4%, compared to the S&P 500 which annualized a much lesser +4.2% over the same period. Looking back further, a hypothetical $1,000 investment in Russell 2000 at the start of 1979 was worth $29,742 at the end of 2014, while the same investment in the S&P 500 would have been worth $21,468. That’s a +2,874% gain versus a +2,047% gain, a difference that isn’t exactly a rounding error!
I’ve just argued for the long-term, total return reason to own small caps in your portfolio, but I think there are circumstances now that could boost the performance of small caps over other categories over the next year.
1) The Dollar Is Strong and Likely Getting Stronger – small cap companies consist largely of U.S.-based companies that derive a large percentage of their revenues and profits from domestic consumers. That means they are largely insulated from the hindrance to exports caused by a strengthening dollar, which multi-nationals “feel” on their top lines.
2) Rising Interest Rates Shouldn’t Hurt – a rising rate environment generally hurts small caps since they are more leveraged than larger companies. High levels of debt in a rising rate environment hurts small companies because interest payment costs rise. But since interest rates are basically zero bound and the Fed has made it pretty clear rate rises will come very gradually, this should not be as negative a factor where it has been in the past.
3) Merger and Acquisition Opportunities – often, small caps are the targets of M&A activity since they’re the easiest targets. That usually means a nice boost for stock prices, since the ‘acquiring companies’ usually have to pay a premium for ownership. In the U.S., if M&A activity continues at its current pace, it could reach $4.58 trillion which would be the biggest year on record.
Bottom Line for Investors
Small cap stocks have proven over the long-term that they deserve or, perhaps, even require a place at the table when investors are making asset allocation decisions. I believe this to be true over the long-term – and, I think the narrative of small caps being ‘too risky and volatile’ is causing investors to slight them when they construct investment portfolios.
Past performance is no guarantee of future results. Inherent in any investment is the potential for loss.
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