Small-cap stocks are often overlooked and misunderstood, according to Francis Gannon, co-chief investment officer at Royce Investment Partners.
But now is an opportune time to pay attention and learn more about them, Gannon said in an interview Monday.
Small caps, those companies that have $2 billion or less in market capitalization, have been “treading water” since March of 2021, but they’re poised for a comeback, said Gannon. Royce is a New York City-based family of mutual funds that focuses primarily on small-cap investing.
“Small caps historically do well when interest rates are rising,” Gannon said, but advisors often overlook this connection. “Small caps have had bland performances the past two quarters. However, today’s atmosphere is providing hope that the tide is beginning to turn.”
The Russell 2000 has posted returns above its historical averages in one-year periods when the 10-year Treasury has risen. Over the past 20 years, in rising rate environments, the Russell 2000 surpassed the Russell 1000 by 73%. We have “confidence that small caps are positioned to outperform U.S. large caps, as well as domestic fixed income and cash, moving forward.”
Small caps were down on average 3.5% since March 2021. “But the fundamentals are still strong, and we are now at a moment when small caps are going to come out of the downturn and go up. Earning power in the future is going to be strong,” Gannon said.
Small caps were doing well when Covid hit in early 2020. After that, the small-cap market suffered even more than larger businesses, going down by almost 50% in some cases. Risk and volatility are often seen as the disadvantages of small-cap investing, but that panic is misplaced, Gannon said.
“When the panic of the pandemic passed, small caps rose to new highs last March and then plateaued,” he said. “Now the opportunity is at hand. People are nervous about inflation,” but that fear is unfounded if rates are rising, he added.
Since large caps have driven the market, smaller companies have been eclipsed. Instead of forgetting them, Gannon said, investors and advisors should be looking for innovative companies in the cyclical areas of the market. The advantage of investing in small-cap stocks is the opportunity it presents to beat institutional investors through growth opportunities.
“For an active manager, this is an opportune time. Most advisors’ clients are underweight on small caps,” he said. Investors on average have about 4% of their portfolios in small caps. “That should be higher.”