Is it finally time to buy small caps?
Markets: Taking a closer look at whether the rotation into small caps is real
First of all, I would like to extend a warm welcome to all our new readers. When markets are in turmoil, as an investor, most of us ignore it and stay invested for the long term. Others use it as a learning opportunity, make savvy moves to profit from it and set up for the next wave of highs or lows. Here in the Beachman community, we do a bit of all of the above. We pay close attention to fundamentals, valuations and market signals with a healthy dollop of macro readings. We don’t over analyze, overthink or overreact. In many ways, we keep it simple and sleep well at night. We are happy that you have joined us here. I am grateful for your time and readership.
Now let’s talk about investing…
On July 11th, we got a very benign CPI retail inflation report for the month of June. Inflation cooled to its slowest pace since 2021, driven by a significant slowdown in housing costs and cheaper gasoline.
Since then, small cap indexes have risen about +10% after going nowhere for much of the previous 6 months. The initial moves higher were driven by short term traders and computerized algorithms. This was then followed by mutual funds and etfs that had to buy more small caps due to their portfolio management rules. Small caps that have been heavily shorted then added short-squeeze fuel to the fire.
While all this is in play, investors are left wondering if this is a viable, sustainable rotation into small cap stocks. We are trying to decide whether it is finally time to put some money to work in these beaten down companies that have been hurt by higher-for-longer interest rates in the US. If yes, then how and where?
The case for owning small caps
Small cap stocks are small for a reason and this in itself should have us treating them differently in our portfolios.
These companies are relatively young in their business life. Often, they have a limited market and therefore lower sales volume. They might just not want to grow bigger than where they are today…happy with what and how they are doing. Many small caps are small because there is high risk involved in their business - they are highly capital and cash flow dependent. It is harder for them to borrow money to grow without paying a premium for the debt. In the current high interest rate environment, business conditions are particularly constrained by market liquidity and consumer demand.
Today, the SP500 index sports a PE (price per earnings) of 20.6, the SP400 mid cap stocks are at 15.7 and the SP600 small caps are at 15.4. These prices reflect the fact that mid cap and small cap stocks are not that profitable. In fact, about 40% of the Russell2000 small companies are currently losing money. Therefore small caps need help from markets, investors, lenders and governments in order to succeed. When they receive such support they thrive and could provide a tremendous boost to investor portfolios.
Over the last 30 years, small caps have returned about +10% annualized as compared to their larger cap brethren who have printed about +12% annually. Over the last 3 years, small caps have not done much, significantly underperforming large cap stocks.
That said, Jefferies analyzed seven similar periods of significant underperformance of small vs. large stocks.
On average, after these difficult periods, small caps outperformed large caps by +22%, +11%, and +10% annually over the subsequent 1, 3, and 5-year periods, respectively.
It is this outperformance that we want to capture in our portfolios. But we need to get the timing right in order to accomplish this.
Is the timing right to buy now?
For the past two and a half years, the US Feds have been on an interest rate rampage…raising rates to some of the highest levels in recent history…with the goal of clamping down on inflation. Now that inflation is consistently trending lower, their mindset has changed from “should we raise more?” to “when should we make the first cut?”. This is quite a shift in tone and focus for the committee. It bodes well for small cap stocks. It gives us the first hint that the timing might be getting close.
Lets remember that, since 1950, small cap stocks have averaged a +27% gain during the 12 months following the US Feds’ first rate cut. This as compared to +24% from mid cap stocks and +15% for large caps.
Markets are almost a 100% sure that the first rate cut will come in Sept. The odds of a fatter 0.50% cut in Sept are also rising. Since late last year, I have been expecting the first 0.25% rate cut at the US Feds July meeting. I still believe we will get it.
Even if we don’t get the desired first rate cut this week, given Chair Powell’s recent dovish commentary, he is expected to acknowledge two things:
There has been solid, sustainable progress on bringing inflation down.
The jobs market is getting weaker with less job openings, more layoffs, more jobless claims, lower wage growth and an uptick in unemployment.
Markets will take such dovish comments as a positive for future rate cuts and they will front run a possible move higher by loading up into small cap stocks. One could argue that they have already started doing so.
Additionally, if you look at how mega cap stocks and small cap stocks have performed over the past two weeks, there are several days during which both these asset classes were higher for the day. This supports the thesis that the so called rotation was not actually a rotation, but new money coming from somewhere else and into small caps. This would constitute a major change in tone for these markets after about two years.
2024 is a presidential election year in the US. Recent polls suggest that the GOP could make significant gains in the legislative and executive branches of the new administration. The GOP is focused on devaluing the US$, increasing exports, tariffing imports and bolstering onshore manufacturing. About 2/3rd of businesses in the US are small to medium sized businesses that could significantly benefit from such policies.
So yes, the timing is right for legging back into small caps.
Now is the time.
But let’s get a bit more surgical on our approach.
Beachman’s small cap investing plan
There are two ways in which I am investing in small caps.
ETFs and mutual funds
I have a couple of tax free retirement accounts in which I can only choose from a handful of mutual funds.
In these accounts, I typically allocate about 15% to a mid cap index fund and 10% to a small cap index fund.
Last week, I bumped up both these allocations to 25% each.
I trimmed my large cap SP500 index fund (VINIX) by 40% and allocated all those funds into the mid cap (VIMAX) and small cap index (VSMAX) funds.
I keep my moves in these retirement accounts very simple:
I use low cost index funds from Vanguard or Fidelity.
I trim them when they are 25% higher than the previous add.
I add to them when they are 10% lower than the previous add.
I usually hold about 10% cash on the side at all times.
In special circumstances, I go overweight into a sector that could benefit. e.g. When we are due to get our first rate cut, I go overweight in small caps. When the US$ goes lower, I go overweight into international funds.
Nothing fancy here. These are retirement accounts and I am too young to withdraw from them. So I am building them up for the long term. I can only choose from a few mutual funds, so the moves are relatively simpler and infrequent.
Why a mid cap mutual fund? In recent times, many good quality startups are IPOing into mid cap valuations, skipping the small cap universe altogether. Additionally, small cap stocks grow as their business thrives, becoming mid caps, getting upgraded from the small cap index into the mid cap index fund. Therefore, mid caps are usually a healthy blend between larger and smaller companies…best of both worlds bringing better business fundamentals together with higher return potential.
P.S. The retirement accounts mentioned here are not part of my Beachman portfolio, however they are a critical part of my overall financial and retirement investing plan.
Beachman’s portfolio
In my Beachman portfolio, I plan to get more surgical with my small cap moves.
There, I tend to buy individual stocks, cryptos and alternative assets. I prefer high-beta, high-growth opportunities that can juice my portfolio returns. I get more specific with how I read markets, how I track macro trends, how I analyze company performance and how I buy, sell, add or trim my positions.
My small cap related moves will be similarly specific and planned. Here’s why…