Investors Spot Bargains Among Small-Cap Stocks https://www.wsj.com/articles/investors-spot-bargains-among-small-cap-stocks-11654046091
By Karen Langley
Shares of smaller U.S. companies have taken a drubbing in the market selloff. Some investors say they are starting to see a deal.
The Russell 2000 benchmark of small-cap stocks has fallen 24% from its November record, beginning its decline almost two months before the S&P 500 index of large-cap companies. The S&P 500 is down 12% over the same period, dragged lower as investors realized that red-hot inflation was sticking around and that the Federal Reserve would likely raise interest rates more aggressively than had been expected.
It is common for small-cap stocks to fall particularly hard during times of economic uncertainty. Stocks in the small-cap category are generally considered riskier investments: Even in good times, many of the companies don’t dependably make money, and that proportion rises during periods of economic distress.
Among the small-cap stocks that have struggled this year: teen-apparel retailer Abercrombie & Fitch Co. [US:ANF], down 41% in 2022; burger chain Shake Shack Inc. [US:SHAK], down 33%; BioCryst Pharmaceuticals Inc. [US:BCRX], down 33%; and Customers Bancorp Inc. [US:CUBI], down 37%.
Stock-market leadership trades off over time between shares of large-cap and small-cap companies. While it is hard to predict when the next rotation will kick off, investors say some small-cap stocks have fallen so far that they now look inexpensive, compared with shares of larger companies.
“We just think that small caps have fallen too hard,” said Jason Pride, a chief investment officer of private wealth at Glenmede, which has maintained an overweight position in small-cap stocks.
The companies in the Russell 2000 had a median market value of a little less than $1 billion at the end of April, compared with almost $30 billion for those in the S&P 500.
If the small-cap group’s recent performance is any guide, other investors are also questioning the extent of the recent declines. Since its 2022 closing low on May 11, the Russell 2000 has gained 8.5% while the S&P 500 has added 5%.
Strategists at BofA Global Research wrote in May that the Russell 2000 had already fallen much of the way toward its average decline in times of recession, while the S&P 500 had dropped about half as much as its average recession-era slump.
“If the probability of a recession continues to rise, both indices likely have further to fall—but historical moves suggest greater downside risk potential from current levels for large than small,” they said.
The Russell 2000 traded at the end of April at 12.5 times its projected earnings over the next 12 months, below the average since 1985 of 15.4 times, according to BofA. That valuation puts the small-cap benchmark at its cheapest relative to the large-cap Russell 1000 since 2001.
The calculations exclude companies without earnings, a sizable share of the small-cap benchmark. Unprofitable companies made up 29% of the market value of the Russell 2000 at the end of April, according to a Jefferies analysis based on earnings over the past 12 months.
That lack of widespread profitability is one reason that shares of small-cap companies tend to take a dive at the first sign of uncertainty about the economic outlook.
Small-cap valuation relative to large caps
“Any whiff of economic slowdown or geopolitical risks, people are going to shoot first and ask questions later,” said Will Nasgovitz, chief executive and portfolio manager at Heartland Advisors. “Small caps are inherently more volatile, and there’s just been pressure on those shares.”
The Russell 2000 plunged further than the S&P 500 in the initial Covid-19 selloff in early 2020, only to turn around and lead the market higher after promising vaccine trials raised hopes for stronger economic growth. More recently, small caps faded after the Omicron variant threw the reopening trade into doubt.
Abercrombie shares dropped 29% in a single session last week after the retailer swung to a quarterly loss and warned of continued higher costs and slower sales growth. BioCryst Pharmaceuticals shares declined 38% in one trading session in April after the company said it had paused enrollment in a set of clinical trials.
Small-cap stocks historically have struggled ahead of recessions but then outperformed in the early stages of expansions. While it is an open question when the U.S. economy will enter its next recession, that eventual leadership is one reason that money managers say it is important to stay invested in the group.
“Small-cap stocks tend to beat large caps when you’re coming out of a recession, and in particular that outperformance often begins well before that recession ends,” said Brandon Pizzurro, director of public investments at GuideStone Capital Management.
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