There are about 30 million companies in the United States, and 99.9% of all companies in the U.S are considered small companies. Small-cap stocks have a history of outperforming large-cap stocks often despite the vicissitudes of the economy. From 1972 through 2019, the annualized return generated by small-cap stocks and large-cap stocks was 12.8%, and 10.7%, respectively. Given that, there seems to be a favorable outlook to be expected from small-cap stocks in the long run, and 2021 could turn out to be a year in which small-caps dominate.
Small-cap stocks are undercovered
Small-cap stocks are the shares of small companies while large-cap stocks are the shares of big companies. Investors often misinterpret these terms and believe they can only make high returns by investing in large-cap stocks, which is not entirely true. Because of this, investors often make the mistake of missing out on good investment opportunities.
Every investment should come with a good amount of research done on the company and its stock prior to investment. Small-cap stocks have low valuations compared to large-cap stocks which makes them a good investment. In the Russell 2000, small-cap stocks have managed to be at normalized valuation levels through most of the years. But, historically, on multiple occasions, small-cap stocks have appeared to be very attractive. As shown in the figure below, in ’90 s, 2000, 2003, 2008, and in 2020, small-cap stocks were greatly undervalued which made them attractive for investment.
Even on the back of a stellar performance in 2020, many small-cap stocks remain hidden from the general investing public and Wall Street analysts, which presents contrarian investors with an opportunity to exploit.
Small-Cap stocks surged last year
Last year, small-cap stocks outperformed both large-cap and mid-cap stocks generating a 20% return in the Russell 2000 index, while large-cap stocks in S&P 500 generated 16%, and S&P mid-caps 400 generated 13.7% of total returns. In the S&P Dow Jones indices, the 5-year annualized return for small-cap stocks was 14.33%, and the one-year total return was 46.30%, which shows in the long run, small-cap stocks tend to provide much higher returns than large-cap stocks. If the economy rebounds in 2021, it will greatly benefit small companies because of their sensitivity to the economy, and small-cap stocks are known to be the best-returning assets after a bear market.
According to YCharts, the best small-cap value stocks and small-cap growth stocks to invest in are shown in the tables below.
If you look at the current share prices of the companies listed above and compare them with prices in the 1st quarter of 2020, you’ll see a noticeable increase in the prices, especially the ones in the growth category.
Although there is more risk associated with small-cap stocks than mid-cap & large-cap stocks, small-cap stocks have a strong ability to generate stellar returns in the future if an investor executes the necessary due diligence to filter out the good from the bad.
Why Invest in Small-Cap Stocks?
Many investors invest in large-cap stocks because of less volatility and large cash balances which gives them confidence in a global crisis. But large-caps tend to earn lower returns in an economic recovery. There’s a strong correlation between small caps and the economy. Small-cap stocks in the Consumer, Financial, Healthcare, Industrials, Materials, Utilities, and Real Estate industries have outpaced large-cap companies depending on consumer demand. At this point, even with macroeconomic conditions such as having a weaker US dollar, small-cap stocks are less impacted because these companies generate their revenue domestically. They also have an advantage with fluctuation in inflation, as small-cap stocks are less affected by fluctuations in prices of products and services than large-cap stocks.
As many cons as there can be investing in small-cap stocks, investors should focus more on the opportunities. There’s much growth potential in small-cap stocks than in large-caps because there’s more room for growth in small-cap companies. There can also be a possibility for an increased likelihood of inefficiencies in the market due to a lack of historical data and public information available on small-cap companies unlike in large-cap companies. But these inefficiencies in the market will allow investors to make huge returns. So, we believe this is the best time to invest in small-cap stocks as the economy will gradually start recovering.
Moreover, small-cap companies also have the advantage of using Federal aid to mitigate the threats arising from the economic downturn. Safeguarding the interest of small companies in the United States is now recognized as a national interest because of their collective contribution to the economy, and this is a positive sign. In addition to the stimulus provided last March, the U.S government passed another stimulus bill of $1.9 trillion in January which included the Paycheck Protection Program, changes to Paycheck Protection Program loan taxations, receive of grants, and tax credit eligibility changes, to provide economic aid for hard-hit small companies. This funding will help small companies to significantly reduce costs associated with their operations. As the government continues to propose more bills, and with the possibility of more stimulus from the U.S government, small-cap stocks should continue to grow and outperform in the market.
Investing in a large-cap stock does not mean it’s always a great investment. All big giants leading the stock market were once small companies, and every small-cap company eventually becomes a large-cap company if resources are used efficiently to create wealth. Our stance on small-cap stocks is that, even though investing in small-cap stocks can have higher volatility, they can also be very rewarding in the long haul.
Disclosure: The author did not own any shares mentioned in this article at the time of publication.
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