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The small-cap stock market sector has bewildered, disappointed, and frustrated some investors—both professionals and individuals—for about 20 years now. The sector, consisting of companies with a market cap of about $250 million to $2 billion, has just not performed well, compared with the big- and mid-cap sectors. Examples of such small-cap companies include specialty material company ATI Inc., and piping systems manufacturer Mueller Industries.

It now appears that small caps are cheaply valued compared to big-cap equities and could make a profitable addition to portfolios while also adding diversification. At some point, this could be true, but when? Looking at some statistics might help. 

In early June, according to Morningstar, the small-cap S&P Exchange Traded Fund, or ETF (symbol: IJR), showed historical yearly earnings growth from the last five years of -0.06% (yes, negative). Morningstar estimates annual long-term earnings growth for the next 3-5 years at 11.20%. That is a total expected increase of 11.26%. 

Compare that to earnings for the big-cap S&P 500 ETF (SPY) over the last five years, which were 7.32%. Its estimated yearly long-term earnings growth for the next 3-5 years is 11.70%, for a total expected growth increase of just 4.38%. (Disclosure: As an investor advisor representative, I have bought IJR and SPY, for clients.) 

Consider another crucial measure: the price/earnings to growth ratio (PEG). This figure compares a company’s earnings growth to its market price. A ratio of 1 is considered reasonable, and the lower the PEG, the cheaper the valuation. Morningstar estimates a PEG of 1.32 for the small-cap IJR vs. 1.85 for the big-cap SPY. 

The small-cap asset class is selling at a lower PEG even though its earnings are expected to increase more than large-cap class earnings. Usually, you’d pay more for the faster grower, but in this case, it’s the opposite.

Growth and Risk Potential

However, there are problems with the small-cap asset class. And one of those is past earnings. Since 1990, stocks in the Russell 2000 small-cap index have included many non-earnings companies reporting operating losses. This has happened in a low-interest rate environment. Interest rates have increased recently, prompting some to think that times might get harder for the small-cap sector.

As Ryan Grabinski, portfolio manager for Strategas, told Worth in an email, “Higher long-term interest rates are likely to remain a headwind for unprofitable companies, especially those who have never earned profits before. The Russell 2000, in particular, is home to a large share of these types of companies.”

Still, there is hope for small-cap performance because of cheap valuations. “The small-cap index sells at a 32 percent discount to the 20-year average relative price/earnings multiple to the S&P 500 Index,” said Sam Stovall, the chief investment strategist at CFRA Research. 

He points out that many small-cap investors are waiting for the Fed to cut rates, which could help the stocks. However, there is also concern that rates will not be cut, perhaps triggering an economic slowdown. Stovall adds, “Small cap stocks get hit the hardest of all cap sizes during a recession.”

Being small is an advantage from the standpoint of starting from a smaller base, making it easier to achieve better growth. However, smaller companies may have a harder time raising capital than larger ones. This can be a limiting factor for operations and growth and is more costly when interest rates are rising. 

There are additional risks. Small-cap stocks are usually more volatile (with greater price movements( than bigger-cap stocks. Some small caps have smaller numbers of outstanding shares, leading to those shares not being actively traded. This makes buying and selling positions harder, especially in times of low market activity.

Possible Growth In Manufacturing

Globalization destroyed many U.S. manufacturing communities that had flourished for years and caused pain for many middle-class and lower-income families in large swaths of the country. 

Binyamin Applebaum of the New York Times points out that in a small factory town in Illinois, the city’s population declined, and household income dropped 27% in 14 years. There are many other examples of working-class areas declining throughout the U.S due to globalization. 

Growth of Non-Earning Companies in the Russell Small-Cap Index

But despite these setbacks, the U.S. is still the second-largest manufacturing country, behind China (with about four times the population). America’s $2.60 trillion manufacturing sector accounted for about 16% of global manufacturing in 2021, according to data from the U.S. Bureau of Economic Analysis and the International Monetary Fund,

The small-cap sector could benefit if U.S. manufacturing grows. A glance at IJR shows that 17.49% of its portfolio is in the industrial sector—its biggest sector holding—and this includes manufacturing. Recent signs point to less manufacturing outsourcing in the future and more goods being produced in the United States. 

The pandemic brought out the problems inherent with the global supply chain. The plan of having countries, including China, making products cheaply and supplying them throughout the world collapsed under the weight of U.S./China trade tensions. The U.S. announced tariffs on Chinese products, and China retaliated with tariffs on American goods.

A recent development boosting U.S. manufacturing is the workforce training programs created by new laws promoting U.S. manufacturing, including the American Rescue Plan, Bipartisan Infrastructure Law, CHIPS and Science Act, and the Inflation Reduction Act. This effort to bring jobs back home, depending on how successful, could create more manufacturing activity and help the small-cap stock sector, since its companies operate mostly in the U.S. 

American manufacturing could boom, but it may not help big-cap companies as much, since they usually operate all over the world. Big-cap companies have been at the forefront of the rush to grow through international expansion, which could be reversed somewhat.

Chances for Near-term Performance 

Standard & Poor’s senior analyst Howard Silverblatt says  it is hard to calculate the cycle when one cap size will start outperforming another. Over 20 years, the S&P 500 Index (big cap) and S&P 600 Index (small cap) have almost the same performance: 560.15% to 497.51%.

Small Cap vs. Large Cap Growth Over Time

Over 25 years, there is about double the return for small cap: 556.21% to 1006.18%. This shows how difficult it is to calculate reversion to the mean, which refers to assets not outperforming or underperforming  indefinitely.

“We go in cycles,” Silverblatt told Worth, emphasizing that small caps will outperform for a while, and then big caps or mid-caps will dominate. “There’s more volatility in small caps,” he said, referring to their higher risk. He also pointed out that small-cap companies usually have more leverage (borrowing for operating capital, expansion, or other purposes), making them more vulnerable to higher interest rates. And they usually have less access to capital. But they could be worth the risk. As Silverblatt opined, “You buy small cap for growth.” 

Joseph O’Malley, strategist at Invesco, Ltd., said that a case can be made for small caps in this environment, even though it may take a while to be profitable: “We’ve seen big caps outperform for the last several years. Eventually we’ll see that performance reverting to the mean.” 

Ways to Invest in Small Caps

Investors who would like to include small-cap stocks in their portfolio have several options. They can simply pick the ones that they like, based on good earnings prospects, a reasonable PEG ratio, and other promising fundamentals. Or they can buy an index fund, which holds securities selected to match a set strategy and are packaged as a mutual fund or an ETF.

Investors can place ETF trades through an online account or through a broker during market hours. Mutual funds execute their trades once a day, after the market closes, and orders can be placed through a stockbroker or directly with the fund. 

The S&P 500 Index is the best-known index of big-cap U.S. stocks, including the 500 leading companies chosen by the S&P committee to represent the U.S. economy. The S&P 600 is designed to capture the U.S. small-cap market segment.

 There are other index funds like the S&P 500, trying to capture the broad market. Broad market index mutual funds are inexpensive, charging about 0.15%. ETFs that replicate the broad market charge about the same. 

There are many other indexes that use different weighting models than the broad market strategies, and these strategies can be traded in mutual funds and ETFs. Funds and ETFs using these indexes have much higher management fees; some charging over 0.80%.

Indexes are hard to beat. S&P compares active mutual funds, in which professional money managers make stock-picking decisions, to its index benchmarks, without tax considerations. The results completed as of the middle of 2023 showed that over the past 20 years: 93% of active funds underperformed the S&P Composite 1500; 94% underperformed the S&P 500; and 94% underperformed the small-cap S&P 600.

Down Markets Can Force Funds to Take Gains

If taxes are considered, the index performance would have been even better against active funds. Many taxable capital gains were paid by funds in years that the market was weak or declining. Part of the reason probably was that funds had to sell stocks to redeem fund holders who wanted out of the market, and some of the fund sales were at a profit.

Is it Time to Act?

Many small-cap stocks have growth possibilities, and earnings projections forecast that some small-cap companies could do better soon. (To be fair, there are also projections showing the opposite.) Many small-cap companies offer value, having lower valuations than their big-cap siblings. 

This might be a good time to consider dollar-cost averaging, where you buy a certain amount, say $2,000 worth, no matter the price, and buy a certain amount periodically. Another way to buy periodically is if the stock or index goes down 5 %, you buy another amount, this time $3,000 or $4,000—whatever fits your portfolio size and budget. If you always buy at a cheaper price, you’ll buy below your average price. Or decide on how much of your portfolio that small cap should represent, say 15% or 20%, depending on how aggressive you want to get and what your risk profile can stand.

It’s true that many small-cap stocks have risks and are underperforming. But money is made when stocks with risks and long-term underperformance are bought for long-term gains.