Some advisors regard small-cap stocks as the undesirable runts of the equities market, far inferior to large caps and unworthy of consideration for their portfolios.

Yet every so often, runts turn out to be the most robust members of the litter. The current market may be one where small-cap runts become strong relatively soon.

The negative reputation of small caps among many advisors is historically undeserved. Though the Russell 2000 underperformed large caps over the last half of the long bull market, the index has had a rolling three-year average return of nearly 10% since inception in 1979.

But after the last few years, characterized by poor performance, this long-term record doesn’t hold much sway with the what-have-you-done-for-me-lately crowd.

Performance until June served to reinforce that view. In May, the Russell 2000 appeared to be on track for another poor year in 2023, prompting MarketWatch to post an indecorous headline May 19: “Small Caps Suck.” Yet it went on to ask: “Is this the time to buy small caps?”

As things have turned out, this was a good question to pose at the time. In June, the index turned upward, boosting overall Q2 performance to a gain of 5.2%. It has continued its upward trajectory in July, reaching 1984.52, a gain of nearly 11.77% YTD July 20—a stone’s throw from the 2023 high-water mark of 2007.31 reached in February—before taking a long escalator down and languishing on the lower floors until June.   

Advisors who enunciate “small cap” as though they had a wedge of lemon in their mouths may dismiss recent performance as a relatively short-lived uptick. But saying that might be speaking too soon.

Auspicious Uptick?
Historically, it has usually taken a recession for small caps to outperform significantly, leading the overall market out. Yet the summer upswing coincides with that of a confluence of long-term growth patterns. To wit:

• Though weak over the last several years, since its inception in 1978, the Russell 2000 has had a rolling average three-year return of 9.8%. And following weak periods of several years, the index has also come back strong. After five-year periods when the index’s annualized five-year return was less than 5%, this return has been 17.7% over the ensuing three years and 14.9% over five. Having returned 2.7% during the five-year period ended May 31, the Russell would now be on a path to significant growth if this historical pattern ends up repeating (or even rhyming).

• Small caps have a long history of usually doing well after four consecutive months of negative returns, as we had this year. Since 1978, the eight previous times the Russell 2000 has done this, it has returned on average nearly 25% over the next 12 months and about 21% over three years. This year’s four-month drought was the ninth time it’s happened.

• Periods of high concentration in the S&P 500—such as now—have often set the stage for a dramatic shift in small-cap performance relative to large caps. This happened in the 1970s, after concentration in the Nifty 50, and in 2000, after the tech bubble burst.

• When the Russell 2000 breaks 17 consecutive months of negative rolling 12-month price returns, a rare event that occurred in June, this is often followed by decent forward returns.

These trends aren’t recondite information; they’re a matter of record. Institutional awareness of them is probably a strong factor driving a recent surge in inflows to small caps. Buy-low axioms alone probably don’t account for recent strong inflows.

Rising Inflows
How strong? About 88% of unusually large volume purchases in domestic equities from June 1 through June 28 went into small caps according to MAPsignals, after 1,512 buy signals for equities under $50 million.

Despite many advisors’ indifference to small-caps, the category’s valuations are currently below their 25-year averages, while large-caps’ are well above theirs.

And though this disparity has been growing wider lately, over the ultra-long term, it’s nothing new. For some time, investors have been paying a lower valuation for small caps than the S&P 500 but receiving higher growth metrics in return.

Value-for-growth comparisons are nothing less than stark. According to Morningstar as of July 11, iShares Russell 2000 ETF (IWM) trounced SPDR S&P 500 ETF (SPY) on valuation metrics with: P/E, 13.18 to 19.83; price to book, 1.63 to 3.68; price to sales, .96 to 2.23; and price to cash flow, 5.25 to 12.69.

Small-caps’ past and future growth numbers are also superior. IWM had historical earnings of 17.06% to SPY’s 15.83%; expected forward earnings growth of 15.40% to SPY’s 10.88%; plus, a higher dividend yield of 1.87 to SPY’s 1.73.

Though IWM’s numbers aren’t as good as SPY’s for growth in sales, cash flow and book value, numbers for Morningstar’s average small-blend category best them by wide margins.

Regarding sectors, some small-cap ETFs still carry the taint of regional banks, while others, such as industrials (as represented by Invesco Small-Cap Industrials ETF (PSCI), have recently been keeping pace with large-cap industrial funds. Small-cap industrials’ growth is currently driving small-cap momentum funds, so ETFs like Invesco S&P SmallCap Momentum ETF (XSMO) and Invesco DWA SmallCap Momentum ETF (DWAS) have high allocations to them—recently, about 26% and 28%, respectively.

Though industrials have been a standout, investment has been fairly broad throughout sectors since April, indicating investor confidence in the potential for diversified growth.

This breadth may be another factor in small caps’ recently rising river of new investment—at a time when large-cap breadth is still narrow. Large-cap investment in the first half of this year has been concentrated in 20 names, the two most purchased of which have been Microsoft and Broadcom. The average market cap of these 20 large companies is $157 billion, but Broadcom ($340 billion) and especially Microsoft ($2.443 trillion) skew this mean upward as these, and other large-cap behemoths continue to drive the S&P 500.

By contrast, the breadth of current small-cap investment is refreshing and attractive. As more money flows into small companies, this will help broaden the overall market growth, a trend that should benefit active funds and create more opportunities in individual stocks, adding impetus to the emerging bull market.

Dave Sheaff Gilreath, CFP, is a founding principal and CIO of Innovative Portfolios, an institutional money management firm, and Sheaff Brock Investment Advisors. Based in Indianapolis, the firms manage assets of about $1.3 billion. The companies mentioned in the article may be held by those firms, Innovative Portfolios’ ETFs, affiliates or related persons.