Opportunities Where You Least Expect

January 30, 2023 | Jonathan Yung


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Time to buy small caps?

After an underwhelming end to last year, 2023 is off to a relatively strong start. Although the first 3 weeks does not reliably predict future volatility, turning the page to a new year serves as a psychological reset, which allows the market to reveal how investors are repositioning portfolios. For example, we are beginning to see diverging performance trends emerging between large cap and small/mid cap companies.  As early as the summer of 2022, RBC Capital Markets US Equity Strategist, Lori Cavalsina, had begun to highlight the opportunities that may be brewing for the small cap sector after vast underperformance. Understandably so, we did not meet many investors who felt compelled to invest in this segment, given the dominating bearish attitude that prevailed. With that said, as inflation concerns moderate and the end of the rate hiking cycle is in sight, investors are beginning to look for recovery opportunities. Below we review 5 reasons why the small/mid cap sector may fit that bill.

Better Valuations:

The S&P Small Cap 600 forward P/E ratio sits at 14.1X, which is well below the 20 year average of 19.6X. The S&P Midcap 400 trades at 14.4X, which is also well below its 20 year average of 18X. In contrast, the larger cap S&P500 is trading at 17.5X , which is above its 20 year average of 16.8X. Simply put, small/mid cap markets are trading at a discount, and the large cap index trades at a premium. As shown in the charts below, both small and mid cap indexes are at the lowest valuations relative to S&P500. Historically this disparity has coincided with small/mid cap outperformance.

Better Earnings profile:

It is understandable to see earnings estimates for companies with smaller capitalizations to come down when economic growth is vulnerable. However, these earnings revision trends for small/mid cap stocks started earlier and hit a low in June 2022. Investors should appreciate how quickly the analysts downgraded earnings for this segment of the market, considering revisions are just getting started for their larger cap peers. With the possibility of earlier earnings upgrades and greater earnings surprises, the potential exists for outperformance.

Already factoring in a recession:

RBC Capital Markets believes that small caps have already priced in a recession. These small cap companies have been factoring in a retrenchment in manufacturing since last summer when the actual retrenchment did not start until late Fall. They have also been discounting a spike in jobless claims, which has yet to materialize. Therefore, small caps should have less risk to price in on a relative basis to large caps.

Stronger liftoffs when new bull market cycles begin:

Time will tell whether the price troughs reached in 2022 were the lowest level of the bear market. Historically, small and midcaps tend to underperform during the early part of a recession, but begin to outperform roughly midway through the slowdown, which often coincides with an upward move in the unemployment rate. Hence, small caps have been seen to be the first leaders out of recessions and into the early stage of a new bull market.

Diversification benefits

One of the reasons why the large cap index of the S&P500 performed poorly in 2022 was its high concentration in the largest 10 stocks. The top 10 accounted for 24.4% of the index, with many of them related to the technology sector. For the Midcap 400 and Small cap 600, technology only represents 12% of the index, and their largest 10 stocks only representing 6%. These 2 indexes also have more constituents in the financial, industrial, and consumer discretionary sectors offering diversification benefits to its large cap index peers.

In all, for those long-term investors who believe that a recession may be avoided or short-lived, small and mid cap companies may be providing a timely investment opportunity. That said, this segment of the market is known to have higher volatility (i.e. beta) and less investment research coverage. Although these characteristics may be suitable for growth-oriented investors, they may not be appropriate for those with less ability and willingness to take risk. Review your portfolio and financial plan with your advisor to determine what parts of the market you would like to be exposed to.

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