The last decade has proven to be exceptionally profitable for stock investors, marked by significant gains in major indices. The S&P 500 has achieved a staggering total return exceeding 300% since September 2015, while the Nasdaq Composite has outperformed it, boasting over 400% in total returns during the same period. However, not all sectors have experienced the same level of growth. Larger companies have seen their market dominance increase, leaving smaller stocks trailing behind. This disparity is reflected in the S&P 500’s record high concentration, as small- and mid-cap stocks have struggled significantly, with indexes like the Russell 2000 and S&P 600 up only 142% and 155%, respectively.
This situation may present a rare opportunity for investors willing to shift their focus. Historically, small-cap stocks tend to outperform their larger counterparts, although this outperformance is cyclical. These cycles can span from five to 16 years, and current indicators suggest that the underperformance phase for small-cap stocks may soon be nearing its end, potentially opening the door for higher returns in the coming years. Utilizing a specific filter while selecting stocks could further enhance these potential returns.
The Russell 2000 index has significantly lagged the S&P 500, with an average annual return disparity of 5.8% over the past decade—one of the lowest on record for small-cap stocks. Data from Distillate Capital highlights that such a negative return differential has historically preceded periods of considerable small-cap outperformance. Notably, the last comparable instance occurred around the peak of the dot-com bubble; while large-cap stocks suffered post-bubble, small caps fared better, achieving a compound annual return of 3.51% from 2000 to 2009, contrasting sharply with the S&P 500’s negative return.
The potential for small-cap stocks to rebound does not hinge exclusively on dire market circumstances. Past performance has also shown that they can thrive even when larger indices are doing well, such as during economic booms in the late 1950s and 1960s.
Another crucial aspect contributing to the appeal of small-cap stocks is their current market pricing. While the S&P 500 is trading at a forward price-to-earnings (P/E) ratio of 22.2, small-cap stocks are presenting better valuation opportunities. The S&P 600, which comprises consistently profitable companies, has a more attractive P/E ratio at 15.7. This valuation discrepancy reflects the last time small- and mid-cap stocks experienced a similar cycle was in 1999.
However, not all small-cap indices are equally favorable. The Russell 2000 has seen its valuation premium grow compared to the S&P 600 since 2020. This underlines the significance of selecting quality small-cap stocks, with the S&P 600’s focus on GAAP profitability leading to notable outperformance of the Russell 2000 over the past 30 years. Positive free cash flow also proves an effective filter for identifying quality stocks, with those exhibiting such metrics outperforming the broader index across market conditions.
For investors looking to capitalize on this opportunity, the Avantis U.S. Small Cap Value ETF stands out as a strong option. The fund employs rigorous selection criteria, filtering companies based on their cash flow and book value ratios. Although it comes with a slightly higher expense ratio of 0.25%, the quality of the small-cap stocks included could warrant the investment. Alternatively, those preferring a strict index approach might consider ETFs that track the S&P 600, though it’s essential to be mindful of tracking errors inherent in small-cap funds due to lower liquidity.
In summary, the current landscape presents a compelling case for investing in small-cap stocks, particularly those demonstrating strong financial fundamentals. As the market dynamics evolve, astute investors may find that this sector holds undiscovered potential ready for exploration.
