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Small-Caps Have Priced in a Potential Recession
In the banking sector, small-cap stocks have less exposure to the volatile commercial real estate sector and are subject to fewer regulations than their larger counterparts, argues Royce Investment Partners’ Miles Lewis.
Small-cap stocks have been trailing behind their larger peers amid the regional banking crisis and persistent economic turmoil. But some investors argue that small-caps still have robust fundamentals and now can be bought at fair prices.
The S&P 600 Small Cap Index, which covers stocks with total market capitalizations between $750 million and $4.6 billion, lost 1.7 percent year-to-date, while the S&P 500 returned 7.2 percent. According to Wade O’Brien, managing director at Cambridge Associates, and Sean Duffin, senior investment director at Cambridge, small-cap stocks are currently trading at attractive valuations after the recent underperformance.
“Investors should overweight U.S. small-cap stocks, given valuations remain attractive and will provide a cushion if an expected recession unfolds,” O’Brien and Duffin wrote in a recent report. “Banking sector turmoil and the sensitivity of more leveraged companies to higher interest rates have weighed on sentiment, but corporate fundamentals and balance sheets are starting at healthy levels.”
According to the report, small-cap stocks historically trade at a slight premium to large-caps, but now they are priced at a discount of roughly 30 percent to 35 percent relative to their larger counterparts. Small-cap stocks may have already factored in the risk of a potential recession, while large-caps are more exposed to economic challenges, according to Cambridge.
“Historical data suggest small-cap companies tend to underperform large-cap peers when economic activity contracts, but there are reasons to believe that past might not be prologue this cycle,” said Cambridge. “Small-cap companies already trade squarely in the range of valuations typically seen during recessions, while large caps are trading well above these levels.”
Miles Lewis, portfolio manager at small-cap specialist Royce Investment Partners, told Institutional Investor that small-cap valuations relative to those of large-caps are at multi-decade lows. He added that in recent years, the large-cap indices have grown increasingly concentrated in a handful of technology stocks, including Microsoft, Amazon, and Alphabet. That’s a signal for investors in small caps. “When you have those extreme concentrations in large-caps…it tends to coincide with the beginning of very strong secular markets for small-caps outperforming large,” he said.
Lewis is even bullish on small-cap stocks in the banking sector, which tumbled after the collapse of Silicon Valley Bank in March. According to Lewis, small-cap banks are better positioned than their larger peers in a number of ways. For one, they have less exposure to the commercial real estate sector, which has seen significant drops in office occupancy rates since the onset of the pandemic. In addition, while the fall of Silicon Valley Bank will probably lead to more scrutiny on the banking sector, most regulations seem to target the larger banks with $100 billion to $250 billion in assets, Lewis said.
Brendan Cooper, head of client consulting and research at Investment Metrics, which is part of Confluence, stressed that quality matters in selecting small-cap stocks. “The regional banking scare, economic uncertainty and fears of recession have led to more defensive posturing,” Cooper said. “With uncertainty, we can expect the flight to safety to continue, so I think within small-cap attractively priced quality names are positioned well.”
Lewis agreed that investors should focus on good-quality companies and not invest through index funds that provide exposure to the entire market. “There are a lot of people who say we are going into a recession, and small-caps are weaker…That’s true for the average small cap, but not if you hire an active manager.”