Recent market trends have created an interesting investment opportunity within small-cap stocks. Small-cap stocks are shares in companies that tend to be smaller and more regionally focused, whereas large-cap companies tend to be more well-known and global in nature (like the S&P 500).

In addition to size, small-caps tend to have a greater proportion of revenues coming from domestic operations compared to large-cap companies. It is our expectation that the U.S. will grow faster than other developed nations, and that U.S. focused companies will benefit to a greater degree from this growth. Due to this, we believe that small-cap companies will have stronger revenue growth than their large-cap peers for the year ahead.

Also, as can be seen by the chart below, small-cap stocks are factoring in a more significant revision in 2023 earnings estimates compared to their large-cap counterparts. This is likely a result of higher perceived risk of recession for smaller U.S. based companies. As a result, earnings estimates may be more reflective of recessionary conditions, and may be earlier to rebound compared to their large-cap counterparts.¹

Finally, small-cap companies are trading at relatively discounted levels. To examine this, the chart below represents the price to earnings ratio (P/E), a widely used metric for valuation, for large-cap (S&P 500), mid-cap (S&P 400), and small-cap (S&P 600) stocks. Lower P/E stocks are “cheaper” compared to higher P/E stocks which are more “expensive”. Currently, the level reflects a wide discount of small-cap price to earnings relative to large-cap stocks.²

There are, however, several risks when investing in small-cap stocks when compared to their large-cap counterparts.

• Small-cap companies tend to be less mature – creating higher risk and greater volatility of their earnings
• Small-caps, as a whole, have a greater percentage of companies with negative earnings compared to large-caps
• Small-caps can be more susceptible to decline and potential bankruptcy due to competitive forces or market declines

These risks create a higher degree of uncertainty and volatility in small-cap stocks. Therefore, our recommendation is that, while an allocation to small-cap stocks is prudent, the amount of exposure should be considered in conjunction with this higher level of risk.

Based on the information above, Gradient Investments has a favorable view towards small-cap companies. Due to this stance, we have exposure to small-cap stocks in our Tilt Series Balanced, Moderate Growth, and Growth models. In addition, we have an allocation to small-cap stocks in the Endowment Series models.

Sources:

1. AllianceBernstein: “Are Small-Cap Stocks Further Along the Road to Recovery?” 12/13/2022
2. Yardeni: “S&P 500/400/600 Weekly Fundamentals” 1/09/2023