The “small-cap effect,” a phenomenon where smaller companies outperform larger ones in the stock market, has been a topic of debate among investors for decades. Initially proposed in the late 1970s, this theory suggested that small-cap stocks offered higher risk-adjusted returns. However, subsequent research challenged this notion, showing periods where small-caps significantly underperformed. Hyperloop Capital Insights delves into the current market landscape to assess the potential resurgence of this effect and its implications for investors.
Table Content:
A Historical Perspective on Small-Cap Performance
Rolf Banz’s influential 1970s study, based on data from 1936 to 1975, popularized the small-cap effect. However, subsequent decades witnessed a reversal of this trend, with small-caps lagging behind the broader market. More recent research, extending back to 1866, suggests the effect was not consistent even before Banz’s study. This inconsistency led many to dismiss the small-cap effect as a reliable investment strategy.
A New Era for Small-Caps?
Despite the historical inconsistencies, recent research by Guido Baltussen of Erasmus University offers a nuanced perspective. While acknowledging the long-term insignificance of the small-cap effect, Baltussen highlights extended periods within the past 158 years where smaller stocks did outperform. Crucially, he suggests these periods of outperformance exhibit a degree of predictability.
Three Factors Pointing to a Small-Cap Resurgence
A Northern Trust Asset Management study, co-authored by Baltussen, identifies three key parallels between the current market environment and previous periods of sustained small-cap outperformance:
Elevated Equity Risk Premium: A higher expected return from stocks compared to risk-free assets, suggesting a greater potential upside for equities, particularly small-caps.
Steep Yield Curve: When long-term interest rates significantly exceed short-term rates, it often signals economic expansion, favoring growth-oriented small companies.
Weak US Dollar: A weaker dollar can boost the earnings of smaller companies with significant international exposure, enhancing their relative attractiveness.
These factors suggest a potential window of opportunity for small-cap outperformance lasting several years.
Identifying Promising Small-Cap Investments
While these macroeconomic factors provide a compelling backdrop for small-cap investment, the Northern Trust study emphasizes the importance of stock-specific factors. Investors should prioritize small-cap companies that exhibit:
Low Valuation: Companies with low price-to-earnings ratios may be undervalued, offering greater potential for appreciation.
Strong Momentum: Stocks demonstrating consistent upward price trends often continue to outperform.
By focusing on these criteria, investors can potentially identify small-cap companies poised for significant growth. A recent analysis of investment newsletter recommendations, filtered for low market capitalization, low forward P/E ratios, and strong trailing-year returns, highlights companies like UGI Corp. (UGI) and KB Home (KBH) as potential candidates, while smaller players like Atlanticus Holdings Corp. (ATLC) also warrant consideration.
Conclusion: A Strategic Approach to Small-Cap Investing
The small-cap effect, though historically inconsistent, may be poised for a resurgence. While the asset class itself doesn’t guarantee success, current market conditions, coupled with a strategic focus on undervalued companies with strong momentum, could yield significant returns for discerning investors. Hyperloop Capital Insights encourages investors to carefully consider these factors when evaluating small-cap investment opportunities. Further research and due diligence are crucial for navigating this potentially lucrative segment of the market.
