Barron's Streetwise - Small-Caps Priced for a Decade of 12 Percent Returns?

Episode Date: December 2, 2022

BofA Securities and Research Affiliates make the case. Plus, stock picks. Learn more about your ad choices. Visit megaphone.fm/adchoices

Hey Spotify, this is Javi. My biggest passion is music, and it's not just sounds and instruments, it's more than that to me. It's a world full of harmonies with chillers. From streaming to shopping, it's on Prime. Small caps right now are trading at what we view as a very attractive historic opportunity for valuations, both on an absolute basis and on a relative basis versus large caps. Hello and welcome to the Barron Streetwise podcast. I'm Jack Howe and the voice you just heard, that's Jill Carey-Hall. She's the head of small and mid-cap strategies at B of A Securities. and she says that at the moment, shares of small companies are poised to outperform. And Jill is not alone in that view. Coming up,

we'll examine the case for small caps, and we'll talk about the best ways to invest. Listening in is our audio producer, Jackson hi jackson hi jack this is not really the podcast friendliest of topics i don't think i mean it's a little abstract small companies right small caps well in gen z tiktok parlance to cap is to exaggerate So no cap means I'm not exaggerating. No cap. Mid caps, small caps, even micro caps, but no caps are new to me. I think it's just singular. No cap.

No cap. All right, good. I always like a historical backstory, but we can't point to like Zachariah Small, who invented the small cap or anything like that. It's just companies that are not as big as the others. And it's an arbitrary cutoff, right? Because the value of the market changes over time. So how small is small? If you look at the Russell 2000 index, that's smaller companies. The median market cap there is a billion dollars. And the top market cap is $13 billion. So somewhere in that range.

And when I say market cap, I mean capitalization. That's the share price times the number of shares outstanding. It's how much you would have to pay to buy all the shares. How are we doing so far, Jackson? I think Zachariah Small would be proud. Okay. Well, look, I will tell you, I guess, a little bit of a historical note here. Decades ago, market researchers documented this thing that's come to be known as the small cap effect. That's the tendency of small companies to produce higher average returns than large ones over long time periods. And the theory behind it was that small

companies are risky. So the extra return must be compensating investors for taking the extra risk. But they haven't looked like that lately for a couple of reasons. First of all, large cap companies have been beating small cap companies for a long time. The Russell 1000, those are big companies. That's beaten the Russell 2000 by three points a year over the past decade. The large caps returned an average of 12.8%. It's been all about the bigs for a decade. The other thing is small caps have actually been less volatile than large caps during periods of market stress. less volatile than large caps during periods of market stress. They did relatively well during something called the taper tantrum back in 2013. That's when the Fed kind of hinted about dialing back its bond purchases and investors turned cranky. Small caps

did all right then. During the UK's Brexit referendum in 2016, small caps held up well then. They also did during the COVID-19 pandemic. So that's the opposite of what investors would expect from risky stocks, which is what small caps were supposed to be. There is a lively debate now over whether the small cap effect is dead or just asleep, or even whether it truly existed to begin with. And we can leave that debate aside. We don't need it for what we're going to talk about now. Leave that one to the academics. Our only interest here is whether small caps are unusually cheap. And they

are, although depending on where you look, you might not see it at first glance. And then when you look at the relative multiple of small versus large caps, they're trading at about a 30% discount to where they usually trade historically. A 30% discount sounds cheap to me. That's Jill Carey Hall. Again, she's the head of small cap strategy at B of A Securities. I mentioned earlier that the Russell 2000 is a small cap index. It trades pretty close to 20 times earnings.

That's actually a smidgen above its long-term average. And that is no one's idea, I would think, of deep value territory. So what does Jill mean when she says that small caps are trading at a big discount? She means that they look cheap once you weed out the unprofitable ones. One of the challenges of looking at the index and the data is that, you know, when you look at it on a price to earnings ratio, a lot of small caps don't have earnings. These are smaller stocks that a lot of them aren't profitable. So about a third of the companies in the index actually don't have profits. If you take the Russell 2000 and you remove

the unprofitable companies and a handful of statistical outliers, the price to earnings ratio for the index drops to about 12 versus a long-term average of 15. I know that sounds like statistical cherry picking, but adjusting for profitability is important for two reasons. One of them is that 33% of the Russell 2000 members today have negative earnings. That's up from 20% a decade ago, and it's a record high. One industry is more responsible for that than the others. Biotech has become much lower quality over time. You know, few of those stocks are profitable. You have a lot more earlier stage biotech companies that have come to market. You know, we saw an IPO boom in 2020, 2021. And, you know, that's an area of small caps that we're more cautious on.

There's a second and even better reason to exclude unprofitable companies when you're sizing up the Russell 2000. The adjusted P.E. ratio has been a better predictor of future returns than the unadjusted one. That's based on a B of A analysis of data going back to 1985. analysis of data going back to 1985. Right now, that adjusted PE leads B of A to predict 12% yearly returns for small caps over the coming decade. That's five points more than it predicts for large caps. Really, the only other time small caps were this cheap versus large caps was briefly during the tech bubble periods in 99 to 01. And that ended up being a great time to buy small caps because if you look at, you know, from March 99 over the next seven to eight years, small caps were up about 100 percent and large caps were flat. There's more to like about small caps than their cheapness.

A lot of these companies are more domestic. They're well positioned to benefit from some of the multi-year trends that we see right now, reshoring of U.S. manufacturing. So as a lot of these big large cap multinationals are bringing back their operations to the U.S., they're being forced to spend on capital expenditures. And those CapEx cycles tend to benefit smaller stocks. The outlook isn't entirely rosy. Small companies tend to have bigger earnings declines during recessions than big companies. And we could be on the cusp of a recession now. But Jill says that small caps are already pricing in a recession on the order of the one we saw during the global financial crisis more than 15 years ago.

One way for investors to add small cap exposure is with a low fee index fund. You could pick one that tracks that Russell 2000 index, but I think it's an upgrade if you switch to one that tracks the S&P small cap 600 index. That index has actually outperformed the Russell 2000 by more than a percentage point per year over the past five years and 10 years and 20 years, and it's generally been less volatile. There's a reason.

S&P uses a profitability screen to admit its index members. One fund option there is called Spider S&P 600 Small Cap ETF. The ticker is SLY. Among pockets of the small cap market, Jill prefers value to growth, and she favors the energy, financial, and consumer staples sectors. From a sector perspective, energy, financials are two areas of small caps that rank well in our work. We are expecting a higher for longer commodity price backdrop.

We are expecting, as quality out commodity price backdrop. We are expecting, you know, as quality outperforms financials has actually become one of the highest quality sectors within small caps right now. So those are two sectors that look well positioned, consumer staples, as well as a more defensive sector within small caps as we head into a potential recession. Jill also says that large cap investing has become crowded because everyone is piling into S&P 500 index funds. We've seen the ETFization of the market. We've highlighted that the most crowded ticker out there right now likely isn't a stock. It's the S&P 500. Thank you, Jill. Coming up, we'll talk with another small cap bull about the case for what's called fundamental indexing.

And we'll run through a handful of stock picks from Wall Street analysts and a mutual fund manager. That's next after this quick break. anywhere, anytime. Police have warned the protesters repeatedly, get back. CBC News brings the story to you live. Hundreds of wildfires are burning. Be the first to know what's going on and what that means for you and for Canada. This situation has changed very quickly. Helping make sense of the world when it matters most. Stay in the know.

Download the free CBC News app or visit cbcnews.ca. This episode is brought to you by RBC Student Banking. Here's an RBC student offer that turns a feel-good moment into a feel-great moment. Students, get $100 when you open a no-monthly-fee RBC Advantage Banking account and we'll give another $100 to a charity of your choice. This great perk and more only at RBC. Visit rbc.com slash get 100, give 100. Welcome back. If a profitability screen has helped that S&P small cap 600 index outperform its rival, the Russell 2000, would a value tilt help even more?

Those indexes both weight small caps by market value. In other words, the biggest smalls get the most weight. Jackson, does that make sense? Did you say biggest smalls or biggie smalls? Now I forget. Asset manager research affiliates has indexes that weight companies a different way by fundamental measures of value like sales, cash flow, and dividends. Charles Schwab, for one, sells a fund that uses a research affiliates index. It's called Schwab Fundamental U.S. Small Company Index ETF, and the ticker there is

FNDA. Like fudgesicle, nonsensical, dune buggy, aromatic. It's a smidgen more expensive than the other funds, but it's still cheap with yearly expenses of a quarter point. Since inception in 2013, the fund has beaten the Russell 2000 by nearly a point. Kuei Nguyen, she's the chief investment officer of equity strategies at Research Affiliates. She points to a recent long-waited bounce for value stocks relative to growth stocks as a sign of things to come. She says that small caps,

which have also underperformed for a long time, could be next. If you really think about it, the value reversal has been a big theme this year, right? That's everybody's seen it and everybody's looking around and saying, what's next? And in our opinion, the thing that's going to the next shoe to drop is really small cap versus large cap.

For people who invest in the US, most people have really noticed a significant underperformance of small cap stocks relative to large cap stocks over the last seven to 10 years or so. If you look at it, small caps have typically outperformed large caps by a small amount per year. But over the last seven to 10 years, small cap stocks have trailed large cap stocks cumulatively by 57% in the U.S. Quay's preferred way to invest is, as you might imagine, her firm's fundamental weighted approach. And not just for its value bias. The methodology uses some quality screens. We'll look, for example, at sales, but we also adjust that for leverage, right?

So we don't want to see a company achieve sales by just leveraging up. We look at book value, but we also adjust book value for intangibles. We want to see a company that actually has a strong balance sheet because it has got both book value and intangibles. We want to see a company that actually has a strong balance sheet because it has got both book value and intangibles. Kwe says that screening for quality is particularly important for small caps. A lot of these stocks that are cheap are cheap for a reason. And if you get a small cap stock that's cheap for a reason, and it has a high probability or a higher probability of just going away. With a large cap stock that's low quality, what. And it has a high probability or a higher probability of just going away. With a large cap stock that's low quality, what happens is it becomes a mid cap stock.

Management strains out and they come back, right? With a small cap stock, a lot of times you hit that wall and you just never come back. Like Biave, Kuei has studied historical small cap valuations to get a read on what performance is likely to look like from here. She used a different set of valuation measures in her research, but she arrived at a similar conclusion. And what we believe is that the relative valuations between large cap and small cap stocks are so stretched right now that over the next five to seven years, small cap stocks could really rebound, outperforming their large cap brethren on a global basis by, on average, 3.7% per year.

Thank you, Kauai. I promised some stock picks. Let me give you a handful taken from a Barron's Magazine story this week on small caps. The first two are value names, and they come from JP Morgan, which began tracking a model portfolio of small and mid-cap stocks in mid-July. That portfolio is off to a fast start,

beating the Russell 2000 by about 13 points so far. One of JP Morgan's top small cap picks is Boot Barn, ticker BOOT. It sells Western wear and work boots. Another is steelmaker Stelco, which trades in Canada under the ticker STLC. It has more cash than debt and has bought back nearly one third of its shares this year. Here are a couple of small cap growth picks from Josh Spencer. He manages the T. Rowe Price New Horizons Fund.

Remember, growth is done poorly as a factor this year, so these are for investors who expect growth to come back. Josh's fund ranks in the bottom 10% of its group for one-year returns, but in the top 1% for 15-year returns, according to Morningstar. Among Josh's favorite stocks now are HubSpot, ticker H-U-B-S, and Ceridian HCM Holding, ticker C-D-A-Y. Both of those trade at a fairly high multiple of earnings. HubSpot competes with the much larger Salesforce in sales software, and likewise, Cerot competes with the much larger Salesforce in sales software. And likewise, Ceridian competes with a better known company called Workday on workforce management software. This is not a stock picking podcast. We don't have a lightning round here. Feel free to stick with index funds. And if you already have some small cap exposure,

keep doing what you're doing. Jackson, am I missing anything? I know there's no lightning round, but how do you feel about some thunderous applause? Simulated praise feels pretty good. By the way, I'm filling in as host of the Barron's TV show this week. You can tune in to hear some great ideas from my colleagues, or if you're just curious what my head looks like now. It's called Barron's Roundtable, and it airs on Fox Business on Saturday and Sunday mornings. There's nothing else on then, right, Jackson? Just the U.S. playing the Netherlands in the World Cup. the U.S. playing the Netherlands in the World Cup.

Well, I wish our boys the best, and I want to apologize in advance for cutting into their TV ratings. That's the spirit. Thank you for listening. Jackson Cantrell is our producer. If you have any investing questions, just tape them on your phone. Use the Voice Memo app and send it to jack.how. That's H-O-U--h, at barons.com. See you next week.