Bull vs. Bear: Thinking Big on Small-Caps 

Nick Wodeshick, Staff Writer: Hey Nick! I’m very much looking forward to talking about this with you. I think we’re starting to approach a key opportunity for investors to get ahead of the market trend with careful small-cap investing. 

Nick Peters-Golden, Staff Writer: Hi Nick, excited to get down to business on this topic. In a lot of ways, small-caps can tell us quite a bit more about the economy than a lot of other factors. Especially as the market faces concentration risk from some huge names, small-caps can prove a bit more sensitive. 

That said, while they have a role to play and can provide a helpful temperature check for the economy, I don’t think they’re a good place to go right now for investors. Just as much as they offer potential for growth, so too are they more vulnerable to headwinds than larger names. Of course, I will get into my concerns around small-caps. 

Wodeshick: I certainly cannot pretend that there’s no risk apparent with small-caps. However, I think we’re rapidly approaching an investment space where small-caps stand to benefit above their peers, and now may be a good opportunity to get in ahead of the market. With that said, let’s talk small-caps!  

Wodeshick: Look, when we start to see rate cuts happen, small-caps should quickly become a more valuable investment option. Once the Federal Reserve decides to start trimming interest rates, small-cap companies should begin to see more comfortable borrowing costs.  

With easing borrowing costs, these companies could see a noticeable uptick in profits. These profits could be bolstered by increased consumer spending, which is yet another common effect of lowing interest rates.  

There’s been plenty of debate over when — and if — the Fed will start slashing rates, but optimism is mounting. Fortune noted that analysts from Citi Research are now predicting eight interest rate cuts of 25 basis points will occur between September 2024 and July 2025. If Citi Research is right, the market could see interest rates dropped to the low- to mid-3% area by the end of the summer in 2025.  

“If we see a sharper slowing in the labor market, if we see that unemployment rate rise faster than expected — and in our forecast, we think we might see some of that — that would be even more reason for the Fed to start those rate cuts. But at least on the trajectory that we’re running at now, it looks like they’ll be ready to cut rates in September,” noted Andrew Hollenhorst, U.S. chief economist at Citi Research.

We’re also seeing more indicators from the Fed regarding its satisfaction with the U.S. economy. In a recent appearance before the Senate Banking Committee, Fed Chair Jerome Powell highlighted that the country’s job market is cooling while inflation data is easing.  

While he remained clear that he was not sending signals regarding the timing of rate cuts, he did make some interesting remarks worth noting. On the topic of rate cuts, Powell noted that timing cuts “too late or too little could unduly weaken economic activity and employment.” 

With growing enthusiasm from experts in the market and the Fed itself, it makes sense to preemptively allocate space for small-caps right now. Investors can stay ahead of the curve by grabbing small-cap equities ahead of any potential market shifts. 

Peters-Golden: One of the key arguments in favor of small-caps has been that imminent rate cuts will provide a major lift for small-caps. Many smaller firms take on a lot of debt as they try to grow, particularly those in tech. Cheaper borrowing costs help pretty much all firms, yes, but for smaller firms that rely more on borrowing, it could be a real boon. 

Of course, that tailwind relies on rate cuts happening with enough oomph to really provide that boost. The rate cut discourse has been the economy’s favorite “will they, won’t they” story since even before the Fed stopped raising rates. Multiple times now, over the last year and a half, markets have gotten very excited about rate cuts. They haven’t hit yet, however. 

In reality, I’m not convinced we’ll see more than a single rate cut this year, and there’s still definitely a case for zero cuts this year, too. The U.S. economy, despite a recent unemployment uptick, remains really solid. U.S. consumer sentiment metrics show an uneven, but overall increasingly positive outlook. Whatever signals we get  from the Fed aren’t necessarily an indication that a cut is urgently needed. 

One or two rate cuts would help small-caps, of course, but not as much as many investors would like. That would likely still leave rates significantly higher than before the Fed’s inflation war began. It’s tough to see a world in which rate cuts in 2024 happen with enough oomph to make a real difference to investor consideration of small-cap firms. Also, rate cuts could benefit large-caps that have already outperformed.  

Wodeshick: I think we’re finally starting to see some notable cracks in the road with large-cap investing, especially with these mega-cap tech stocks. Just look at Nvidia, for example. The company’s had an excellent run for most of the year, but we’ve started to see some higher-than-expected volatility in recent weeks.  

I’m not saying a tech or AI bubble burst is imminent, but it should certainly be something investors keep in mind going forward. There may not be some catastrophic sell-off in the works, but the market could eventually hit a breaking point in terms of company concentration.  

For a good portfolio, diversification is key. This extends to equities as well. Looking down to the opposite end of the cap spectrum can help investors find growth and value opportunities that are significantly distant from the large-cap tech players that remain market favorites.  

Sure, small-caps can come with more inherent risk. But this risk is buoyed by the potential to fortify portfolio growth and provide investors with stronger returns. Additionally, choosing the right small-cap investment tools can provide unique opportunities to outperform the market.  

Regardless of whether or not we see a drawdown for large-caps, the current market concentration is creating great opportunities to seek out small-caps trading at great P/E ratios. These ratios could very well narrow as the U.S. economy inches toward an interest rate cut. Therefore, now may be the ideal time for investors to add some small-cap equity exposure to their portfolio.  

“Small-cap stocks are often more economically sensitive than stocks issued by larger firms and can therefore perform better during periods of strong economic growth. They’re also cheaper. Whereas large-cap stocks covered by Morningstar’s equity analysts are currently trading at a 7% premium to their estimated fair value, small-cap stocks are trading at a 14% discount,” said Amy C. Arnott, CFA, Morningstar portfolio strategist in a recent column she wrote.   

Peters-Golden: Whenever we talk about a market segment, we’re really talking about how it performs against the “obvious” choice. In this case, it’s hard to see a performance case to ditch large-caps. Yes, small-caps can offer some diversification — but I’ll get to that, too.  

Let’s stick to performance. It’s hard not to start with the SPDR S&P 500 ETF Trust (SPY A). It, of course, tracks the S&P 500, and as perhaps the most recognizable ETF, it’s a solid option to use as a comparison against small-cap alternatives.  

A look at YCharts shows that SPY pretty comprehensively wins out over small-cap rivals. Value or growth, Russell 2000 or S&P 600, SPY has outperformed over recent and longer-term time frames. Consider this graph: 

SPY has outperformed all of those ETFs — tickers IWM, SLYG, SLYV, and VB — over the last five years per this graph. Over the last one year, too, SPY outperforms. Six months, too, has shown SPY outperforming — three times the next-highest performance of one of those small-cap ETFs, to boot. 

It would be wrong to ignore some of the reasons to eschew large-caps in the first place. Yes, the concentration risk is just that — a risk. AI has contributed quite a lot to valuations among firms with varying degrees of tech focus, and AI could still prove to be a bubble. Those are risks that shouldn’t be ignored. 

That said, those risks have already existed for several months, and large-caps have continued to perform for investors in that time. One could even argue that there is a positive side to the concentration risk in markets when it comes to large-caps — without the 10 largest names, the market would be a lot more anemic.

Of course, all those nice data points in large-caps’ case are backward-looking. The real question is, what lies ahead and how large-caps might do moving forward versus small-caps. That’s a place for the experts.  

Take BlackRock, for example. Its recent market update doesn’t suggest eschewing large-caps, but does suggest adding an active ETF view into the space. Active ETFs have risen significantly in popularity of late, with an ETF like the T. Rowe Price Capital Appreciation Equity ETF (TCAF A-) offering one long-term, large-cap-oriented option moving forward. Active large-cap strategies can adjust quickly to factors like concentration risk or a potential bubble. 

Wodeshick: Investors looking to fortify their portfolio with small-caps may wish to consider the ALPS O’Shares US Small-Cap Quality Dividend ETF (OUSM A). The fund aims to provide investors with access to a robust portfolio of small-cap equities.  

While some small-caps within the Russell 2000 struggle with profitability and floating rate debt, OUSM aims to circumvent that. To do so, the fund uses a fundamental-focused screening approach when choosing new additions to the portfolio.  

In particular, the company focuses on small-cap companies that promote quality, lower volatility, and good dividend growth. By seeking out companies with strong balance sheets, OUSM can mitigate some of the volatility present within a small-cap fund focusing on market rates.  

Through choosing assets based on fundamental metrics, OUSM does have strong exposure to a few specific industry sectors. The sectors with the largest weight within the fund are currently the financials, industrials, and consumer discretionary sectors. Crucially, this sector weighting can help investors keep their portfolio a bit more diversified away from some of the common tech equity options.  

Currently, OUSM is trading with an attractive P/E ratio of roughly 18.45. This presents a nice opportunity for investors to gain exposure to a more risk-adverse small-cap fund.  

Through an examination of fund flows, one can see why investors are choosing to use OUSM’s small-cap strategy, even amid a year of underperformance for small-caps. As of July 7, 2024, OUSM has seen over $130 million in net flows over the last six months. 

Peters-Golden: Listen, I don’t hate small-caps. I just think they’re the second choice for most investor needs right now. For long-term capital appreciation, large-caps have outdone their smaller cousins. But what about diversification? That would really help, given, again, the concentration risk for larger firms and how tech-heavy market leaders are right now. That doesn’t mean, however, small-caps can fit that need. 

Instead, it might be worth looking abroad. U.S. equities can come in different sizes or focus on different areas, but they’re all in the U.S. While obvious, it does bear mentioning that foreign markets have much greater potential to zig when U.S. large-caps zag than, say, small-caps.  

Indeed, foreign equities can also offer plenty of their own upside. Emerging market equities, for example, have their own potential for upside that could provide that helpful diversification, too.  

Emerging markets are benefiting from shifting supply chains after the pandemic threw global supply chains for a loop. What’s more, emerging market indexes pick up on nation-specific trends, like India’s young, rising middle class, or reshoring in Mexico.  

Outside of emerging markets, international equities strategies can help even when they include the U.S. An ETF like the ALPS O’Shares Global Internet Giants ETF (OGIG B-) combines U.S. tech firms with leading internet tech names from around the world. So, while still getting that performance from names like MercadoLibre (MELI), an e-commerce platform in South America, it retains exposure to leading domestic tech names.

Wodeshick: Small-caps have yet to have their moment this year; this is true. However, I believe we will be approaching a point where a careful small-cap strategy can open up potential to outperform the market. With many small-cap options trading at a good discount for now, you may want to get in ahead of the curve.  

Peters-Golden: Small-caps have a role to play, yes. But with other options available, and large-caps still performing, making a big portfolio shift to accommodate small-caps may not make the most sense. 

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