Small caps may be lagging their large cap peers so far this year, but there are some experts who say now’s the time to buy.
So far this year, the Russell 2000—which tracks small caps—is up just 9.5%, while the S&P 500 is up just over 17% year-to-date.
But this gap has taken small caps to their most attractive valuation levels in years compared to large caps, giving investors a great opportunity to buy. It also helps that small caps tend to outperform when inflation picks up and they also aren’t typically as impacted by global trade conditions as they tend to operate domestically.
“Valuations have limited short term predictive power, but matter more over the long term,” wrote Jill Carey Hall, senior U.S. equity strategist at Bank of America Merrill Lynch, in a note. “The relative P/E today suggests that small caps should lead large caps over the next decade.”
Leuthold Group chief investment strategist Jim Paulsen pointed out in a note this week that volatility has spiked recently for small cap stocks compared to large caps, and that, he says, historically has signaled a period of outperformance for the group. Small caps also historically outperform by an average of 6% when the valuation gap between small caps and large caps is as wide as it is now.
Small caps also tend to perform well when the Fed lowers rates. Jefferies data showed that, on average, small caps have a 12-month return of 27.9% after the Fed begins an easing cycle, while large caps return 15% in the same time frame. The Fed has already cut rates twice this year, and is widely expected to reduce rates again at its October meeting.
“Lower rates are boosting housing and that’s a very large portion of small cap earnings and more so than large caps,” said Jefferies equity strategist Steven DeSanctis, who also noted that more than 30% of small cap earnings come from housing.
For many investors, though, small caps are a riskier bet as they tend to be more volatile and unpredictable than large caps.
“Risk-wise, you have to be a bit more careful,” Papamarkou Wellner Asset Management president Thorne Perkin said. “In small caps, you have to really understand company operations and their competitive environments.”
But Hodges Capital’s Eric Marshall says small caps are worth the risk. “Small caps do tend to carry more risk, but they should over time reward investors for taking that risk, meaning they normally outperform over long periods of time.”
Of the two, Wall Street is most bullish on Diodes. Analysts’ average price target for the stock indicates 37% upside over the next twelve months.
Wells Fargo analyst Gary Mobley recently initiated coverage of Diodes with an Outperform rating and a $55 price target – 37.5% higher than the current price. Mobley said in a note that consolidation in the semiconductor industry has helped Diodes to break into the key automotive market, a market that offers growth and margin potential for the chipmaker.