5 reasons why 2022 could be the year of the small-cap

Forget sector rotation. Forget geographic distribution. Here’s why you should think about diversifying your portfolio’s market caps.

Takeaways

• Judged by P/E ratio, small caps – especially pre-profit ones – look incredibly expensive. By other metrics, they can be undersold.
• While the Russell 2000 has been outperforming the Dow for the trailing 12 months, it has dipped over the past couple weeks.
• New tax policy could drive portfolios toward value stocks, which small caps typically are.
• There are lots of way to diversify the small-cap end of a stock portfolio via index futures and ETFs.
• An acquisition target has an immediate 30% upside, and small companies make big targets.

In 2018, Apple became the first trillion-dollar company. Last year, it became the first two-trillion-dollar company. Today, there are half a dozen four-comma names, with Facebook – sorry, Meta – knocking on the door.

Should you have these in your portfolio? Almost certainly. They’re today’s General Electrics, AT&Ts and Ford Motors. But should you focus your portfolio entirely on the companies with the highest market caps?

That’s as rhetorical a question as “Should I only invest in U.S.-domiciled companies?” or “Should I only invest in Consumer Durables?” There are lots of reasons to go down-market when it comes to stock picking. Here are five reasons why you should be paying as much attention to the scrappy Russell 2000 companies as you do to the established Dow 30.

1.   Small caps are cheaper than many think

The most widely used metric to determine if a stock is properly valued is the price-to-earnings ratio. It is simple. It is elegant. It was on the Finance 101 test. But it can be incredibly misleading.

If you’re going to compare two legacy industrial companies in the same segment – say American Airlines and United Airlines – any difference between the P/E ratios can be reasonably ascribed to future prospects and thus to management’s ability to anticipate changes in the environment. But is it fair to compare United with Tetra Tech or Ovintiv?

The fact is,  nearly one-third of the Russell 2000 operates in the red. That’s why the Dow’s composite P/E is around 22 and the Russell’s is a surreal 727.

In this post-dotcom world, who really cares? The IPO market valued Amazon at $300 million when it went public in 1997, and it didn’t show a profit until 2003.

That’s why savvy investors value post-revenue, pre-profit companies via discounted cash flow analysis, price-to-sales ratios, net book value and other benchmarks. If you use those as points of comparison, you might be able to bag better catches than if you used the blunt instrument that is P/E. CB Insights has a great piece on this topic.

2.   Small caps are in a dip

Over the past year, the small cap-focused Russell 2000 index saw a 32% rise, well ahead of the Dow Jones Industrial Average’s 20%.

While the blue-chip index kept chugging along over the past couple weeks, the small caps have given back around 3%. It’s hardly a correction – barely a dip – but where else are there buy opportunities right now?

3.   It’s a value play

How financial transactions will be taxed in the U.S. is a story that’s still being written, but the smart money suggests that capital gains are likely to incur a higher levy. And, while it’s a good sign for equity investors that Jerome Powell will almost certainly retain his Federal Reserve chair, at some point he’s going to have to go with the flow and raise target interest rates.

This could accrue to the benefit of small caps.

“Small-caps can stand out if long-term interest rates rise more than short-term rates over the coming year, steepening the yield curve,” according to Barron’s. “That’s because the small-cap indexes have more of a value tilt, compared with the S&P 500’s mega cap, long-duration growth stocks. More than 40% of the S&P 500’s market cap is in the technology and consumer-discretionary sectors—home to most of the stocks whose pricey valuations are at the greatest risk from higher rates.”

4.   It’s easy to fine-tune your small-cap portfolio

Small caps: How do I buy thee? Let me count the ways …

(I hesitate to quote sonnets these days. One time I asked a lady, “Shall I compare thee to a summer’s day?” She then replied, “Shall I compare thee to a Summer’s Eve?” But I digress.)

You can buy one of three index futures predicated on the Russell 2000, or another predicated on the narrower Russell 1000 or the wider Russell 3000. Or you can buy one underlaid by the S&P 600 index, which lists only those companies which have four straight quarters of positive earnings. Of course, you can also do your own research and analysis then buy the individual stocks which most appeal to you.

5.   Small companies make big targets

“U.S. mergers-and-acquisitions activity has been robust this year, and corporate balance sheets—not to mention acquisitive private-equity firms—remain flush with cash,” Nicholas Jasinski reports for Barron’s. “As relatively digestible takeover targets, small-caps would benefit from the continuation of that trend—either by being acquired themselves or by seeing their valuations rise when competitors are taken out.”

Just holding the stock of a company that is successfully acquired by another is a quick way to make around 30% with the click of a mouse.