Published on October 7, 2022 in the Rochester Business Journal

U.S. financial markets continued to be under pressure this month, with the S&P 500 Index (a proxy for large U.S. stocks) down over 18% from its 1/2/22 all-time high, the S&P Mid Cap 400 Index (a proxy for mid-sized U.S. stocks) down over 17% from its 11/8/21 all-time high, and the Russell 2000 Index (a proxy for small U.S. stocks) down over 25% from its 11/8/21 all-time high, as of the date of this writing. The pressure may very well continue, as the Fed raises interest rates and withdraws other forms of stimulus to bring inflation under control, but one thing’s for sure – if the Golden Rule is to sell high and buy low, things are becoming much more interesting on the buy side of the equation, particularly for small-cap stocks.

Stocks are often compared to one another based on market capitalization, or market cap, for short. A company’s market capitalization is simply the gross value of its stock, calculated by multiplying the company’s total number of shares outstanding by its current price per share. Companies with a market cap of between $300 million and $2 billion are generally considered to be small-cap stocks, or small-caps. Those with market caps between $2 billion and $10 billion are generally considered to be mid-cap stocks (i.e. mid-caps), and those with market caps over $10 billion are generally considered to be large-cap stocks (i.e. large-caps).

Small-cap stocks are thought to be riskier than mid-cap and large-cap stocks because they tend to rely on fewer products and services to generate their revenue and earnings. Larger companies tend to have several different products and services, such that the success or failure of any one product or service enhances or detracts from the top line (i.e. revenue) and bottom line (i.e. earnings) to a much lesser extent. Another way to think about this is to say that small cap stocks have the ability to provide investors with greater upside potential (i.e. more return), while at the same time exposing them to greater downside potential (i.e. more risk), depending on how the more limited part of the market they cater to is performing at any given time.

Small-cap companies tend to feel the pain of an economic slowdown sooner than their mid and large-cap peers, in as much as the products and services they provide are generally, but not always, needed in the early stages of producing a finished good. Accordingly, when demand suddenly declines and orders dry up, small-cap companies are usually the first to feel the pain, and their stock prices are typically the first to suffer. Conversely, mid and large-cap companies have the luxury of selling existing inventory to buoy earnings for a while, without expending additional cash for new purchases when demand begins to wane.

While it’s generally true that small-cap stocks are the first to fall in an economic slowdown and that they tend to fall further and faster than their mid and large-cap peers, it’s also generally true that small-cap stocks tend to recover faster and go on to see larger gains than their mid and large-cap peers when demand eventually returns - more on this in a moment.

As alluded to earlier, small-caps began falling from their peak nearly two months before large-caps did, and since the time both peaked in price, small-caps are down nearly 39% more than their large-cap peers. On this basis and in absolute terms, it sounds as if small-cap stocks may be presenting a buying opportunity, but we should first examine relative valuation for greater clarity on the matter.

Relative valuation considers two things simultaneously: one, how stock prices in a particular segment of the market relate to the expected earnings from that segment over the next twelve month period – this is represented by a forward price-to-earnings (P/E) multiple and is calculated it by dividing aggregate stock prices by aggregate expected earnings; and two, how this forward P/E multiple compares to the 20-year average multiple for each segment.

As of 8/31/22, FactSet Market Aggregates and J.P. Morgan Asset Management report aggregate forward P/Es ranging from 14.5 to 24.9 for small-cap stocks, equating to approximately 70-86% of their historical 20-year averages. Mid-cap P/Es ranged from 13.1 to 21.8 on that date, equating to approximately 91-108% of their historical averages, and large-cap P/Es ranged from 13.2 to 22.7, equating to 97-123% of their historical averages. Clearly, small-cap stocks are attractively priced, if earnings estimates are accurate and if history is any guide.

Although the U.S. market may not have bottomed yet, we do know this: small-cap stocks have fallen more than 25% from their peak and small-caps tend to fall faster/further and recover faster/further than their large-cap peers as demand continues to ebb and flow. Relative valuation also suggests that small-cap stocks are attractively priced, based on forward P/E multiples and how they relate to historic averages in the space. All things considered, now may be a good time to start adding more small-cap exposure to a broadly diversified investment portfolio. When stronger demand finally does return, doing so could be a small way to leverage one’s portfolio to a much bigger recovery.

To see this column in the RBJ, click here.