Don't Give Up on Small-Cap Stocks

A little over a year ago, I said that small-company stocks offered good value – they weren't dead, as many believed.

Sure enough, they woke with a start. In less than six months – from Sept. 24, 2020, to March 15, 2021 – the small-capitalization S&P 600 Index rose an incredible 69%, more than triple the gain of the large-cap S&P 500.

Afterward, however, small caps reverted to the pattern that has prevailed since 2014. Their prices plateaued over the next six months, while large-company shares kept up a briskly consistent ascension. It's not that small caps have done poorly over the past decade. Their returns are well into the double digits and are higher than historical averages. The problem is that in this bull market the little companies have trailed the big ones so badly that it makes you wonder whether the gap is permanent.

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Consider the Russell 2000, a popular small-cap index. Over the past five years, the large-cap Russell 1000 has beaten the Russell 2000 by an annual average of four percentage points and over the past 10 years by 2.6 points. These are serious differences – especially because, historically, small caps have solidly outperformed large caps.

To compensate for their greater risk, small caps have historically scored higher returns. Except that lately – despite that amazing six-month spurt – they haven't. Since 2014, Vanguard Russell 1000 (VONE), an exchange-traded fund linked to the large-cap index, has beaten the Vanguard Russell 2000 (VTWO), an ETF that tracks its small-cap analog index, in seven of eight calendar years, including so far in 2021. (Stocks and funds I like are in bold.)

Has something profound and lasting happened to small caps, or is this period an anomaly that might be in the process of reverting to the mean?

The case for large caps begins with investors' enormous enthusiasm for both S&P 500 Index funds and the stocks with trillion-dollar market values that dominate those funds. Another change that favors large caps is that as technology allows business to become more global, giant companies have a huge advantage, both in efficient supply chains and in marketing brands known throughout the world. Also, in this low-interest-rate environment, large firms can gain easier access to cheap money, so they can grow even larger.

This case makes sense, but I view investments through a dif­ferent prism. In markets, investors shun groups of stocks until those shares become irresistible. Then they jump in, and prices rise. That was the phenomenon that powered small caps from September 2020 through March 2021, which proved that these stocks can still attract investors.

Big Bargains

Small caps are offering undeniable value. According to Morningstar, the average price-earnings ratio for the Russell 2000 stocks that make up Vanguard's ETF is just 16, compared with 22 for the stocks in the Vanguard Russell 1000 ETF. The average price-to-book value for the small-cap ETF is 2.2, compared with 4.0 for the large-cap fund. The Russell 2000 ETF (IWM) has lower valuations despite having higher long-term earnings growth.

Small caps have other attractions, too. The S&P 500 has become almost an internet specialty fund, with the information technology and communication services sectors together accounting for 39% of the total index. Those high-tech sectors amount to only 16% of the small-cap S&P 600. The small-cap indexes have the long-term advantage of being broadly diversified.

Tech stocks, furthermore, are not the only ones that are soaring.

Take Crocs (CROX), a Colorado-based maker of clunky though trendy slip-on clogs. Recently, under imaginative management, the company has grown impressively, its shoes becoming especially popular with teenagers. When COVID hit, investors feared the worst, and the stock lost half of its value. But since March 2020, the share price has risen by a factor of nine. (Take that, Apple!) Despite its spectacular rise, Crocs still carries a reasonable P/E of 20, based on the consensus of analysts' estimates of earnings for the year ahead.

Crocs has increased in value so much that, at nearly $9 billion, its capitalization no longer qualifies as small. The generally accepted limit for a small-cap stock is $2 billion, but that's an old number and probably too low; I would update it to about $4 billion.

Under the Radar

Because they are followed by fewer financial analysts, small-cap stocks can escape notice and become underpriced. That may be the case with Calavo Growers (CVGW), a marketer and distributer of avocados. Calavo's stock, which is covered by only five analysts and has a market cap of about $700 million, is down by more than half from its 2018 high and carries a dividend yield of 3.0%, considerably more than a 10-year Treasury bond.

With a fleet of 247 aircraft, Bristow Group (VTOL) serves offshore energy companies and provides search and rescue work around the world. Although shares have doubled since the summer of 2020 as oil prices have risen, the stock, with a market cap of $966 million, trades far below its record high.

Some of the best small-cap funds are closed to new investors. Access is limited to my 2020 pick, Wasatch Ultra Growth, which has returned 43% in the past 12 months. You can still purchase shares directly from the fund company, though, or crib from its list of holdings, including Vintage Wine Estates (VWE), a Sonoma-based owner of more than 30 upscale wine brands. The stock went public in April 2020 and is tracked by just five analysts.

Many small-cap funds are mid-cap funds in disguise. The average holding of Artisan Small-Cap, for example, has a market cap of $7 billion. That compares with $2.3 billion for SPDR Port­folio S&P 600 Small Cap (SPSM), and $1.8 billion for another ETF I like, WisdomTree U.S. SmallCap Dividend (DES). One of Artisan's holdings is Ingersoll Rand (IR), with a market cap of $22 billion. C'mon. Although there's a place for large- and mid-cap stocks in any portfolio, right now, small is beautiful.

Some good, true small-cap managed funds are open to all. An investment of $10,000 in Buffalo Small Cap (BUFSX) 10 years ago would be worth roughly $49,000 today. Its number-one asset is Everi Holdings (EVRI), a gaming technology company with a P/E of 21. AB Small Cap Growth (QUASX), founded in 1969, has notched an annualized return of 27% over the past five years. (You can purchase the fund with no sales charge at some brokers.) Holdings include John Bean Technologies (JBT), which makes food-processing equipment, and Trupanion (TRUP), which provides medical insurance for pets.

Few investing joys beat buying shares of a small company and eventually seeing them soar. It’s not just the money but the thrill of discovering stocks, in this mega-cap era, that most folks find just too small to notice.