In Defense of Small Caps

Published Tue, Mar 27th, 2012   Louis Basenese, Chief Investment Strategist

A recent article in The Globe and Mail suggested that now would be an opportune time to take profits in small-cap stocks off the table, based on seasonal trading patterns.

Other pundits are suggesting a retreat, too. In their minds, fears of a European recession warrant avoiding traditionally riskier assets like small caps.

Let me set the record straight, though. Now would be a terrible time to abandon small-cap stocks. And here are three reasons why…

The Euro Economies Don’t Matter

I wholeheartedly agree that Europe is on a crash course with a recession. One look at this chart and you’ll be convinced of the same.

But here’s the thing: Small-cap companies aren’t like large-cap companies. Their business is mostly domestic. Heck, many small caps don’t do any business in overseas markets.

So it doesn’t matter if the eurozone economies hit the skids. All that matters is how the U.S. economy fares. And from jobs to housing and consumer confidence to manufacturing, it appears to be picking up steam.

Up in Price…

In addition to an improving economic outlook, the recent trading activity also bodes well for small caps.

Sure, small-cap stocks got hammered in the second half of 2011, dropping about 25% from July 2011 to October 2011. That compares to a 15% slump for large caps over the same period.

Since that time, though, they’ve bounced back impressively. They’re up 38%, outpacing large caps by almost eight full percentage points.

We should embrace such strong momentum, not run from it. Because it’s likely to continue.

As I noted last week, investors are finally starting to come out of their hibernation in cash. That includes hedge funds. As Bloomberg reports, hedge funds are buying stocks at the fastest rate in two years now.

Just because the S&P Small Cap 600 Index hit an all-time high last week, that doesn’t mean small caps have peaked. To the contrary, the Index will likely hit even greater all-time highs. Especially when we take valuations for small-cap stocks into consideration.

…Down in Value

Small-cap stocks might be going up in price, but they’re getting cheaper at the same time. I know, such a phenomenon sounds counterintuitive. But it’s true. Take a look:

Since July 2011, small-cap stocks have gotten 20% cheaper, based on the average price-to-earnings ratio. In comparison, large-cap stocks have only gotten about 5% cheaper.

Bottom line: The economy, momentum and valuations all favor small-cap stocks right now. Like Robert Sluymer, of RBC Capital Markets, says, “I’d be careful concluding that they [small caps] are completely finished for the year.” So forget the naysaying headlines – by turning your back on small caps, you risk missing out on considerable profits.

Ahead of the tape,

Louis Basenese

P.S. – If you’re looking for small-cap investing ideas, we just released our “Top 10 Screaming Buys” list. All you have to do to access it is follow this link.