What's next for small-cap stocks?


Paul Shelton, Vice President - Equity Client Portfolio Manager, Columbia Threadneedle Investments

Changes in stock prices appear on a video screen

Key Points

  • Innovative small-cap companies have the potential to emerge from this unprecedented period in stronger competitive positions.
  • It’s important to make distinctions when considering small-cap equities.
  • With support from their Ameriprise advisor, investors should focus on finding companies with quality business models.

Small-cap stocks can play an important role in a well-diversified portfolio. They generally included companies with market capitalizations between $46 million to $5.9 billion.

Prior to the pandemic, small caps generally underperformed large-cap stocks. Through the market sell-off, small caps (as measured by the Russell 2000 Index) fell 40.9% while the large cap Russell 1000 declined 28.0% for the same period.

Breaking down small-cap performance in the following table reveals a significant divergence in the performance between growth and value benchmarks — a notable distinction for investors.

Small cap growth stocks outperform in 2020

 

Past performance is not a guarantee of future results.

The division in benchmark performance is partially attributable to the composition of small-cap indices:

  • At the end of June, financial stocks comprised more than 28% of the Russell 2000 Value Index. They tend to do better when interest rates are rising, but the Federal Reserve cut rates to near zero as part of its response to the health care crisis. Rates not expected to rise again for the foreseeable future, and this has weighed on the sector.

  • The Russell 2000 Value Index is largely weighted in cyclical stocks, meaning that they do well when the economic cycle is on an upswing. Cyclically sensitive stocks, like energy and industrial companies, have lagged this year because of the uncertain path to economic recovery. We expect a U-shaped recovery over the next 10 quarters. While we may see some dramatic initial gains, in our view it will be a long road back to pre-pandemic levels of economic activity. This could weigh on cyclical stocks.

  • While many industrial stocks are struggling, investors have benefited from the “new economy” companies that are frequently found in the Russell 2000 Growth Index. These include innovative technology firms and health care companies with unique products or services that may fight COVID-19 — and a select group of consumer-oriented firms that can navigate the challenging economic environment.

It might be easy to conclude that buying a passive exchange-traded fund (ETF) is the way to gain small-cap exposure in the current environment. But we believe doing so would be a mistake. Companies with sound business models should be able to emerge from this unprecedented period in stronger competitive positions.

Columbia Threadneedle Investments Portfolio Manager Dan Cole offers his view:

“Small-cap markets have always been a rich source of new, innovative companies. They typically grow faster than peers and the overall economy. A great starting point for investors is to investigate companies with unique products or services. The key is not just to find companies with faster-than-average growth, but to identify those with business models that allow consistent returns on invested capital that are greater than the cost of capital.”

Bottom line: Focus on the business model

It’s important to make distinctions when considering small-cap equities. Discerning investors — with support from their Ameriprise advisor — can find unique companies with strong business models across the asset class as well as across growth and value styles.