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Small-Cap Stocks Are Back in Vogue

After enduring a near-death experience in the later part of 2018, there are now signs of life in the small-cap sector.

Starting in late 2016, the small-cap sector soared on an unbroken upward trajectory as the Russell 2000 index surged past the S&P 500. For most of 2018, small stocks delivered enviable double-digit returns. While the S&P 500 rose 8.5% in the first eight months the year, the Russell 2000 posted a 13.4% return. However, later in the year, the surge in the small-cap sector unceremoniously halted.

Small-cap stocks took a pounding during the last quarter of 2018, with the Russell 2000 index dropping more than 16% from its all-time high in August. The index sank 12% in December alone, ending the year with its worst annual return since 2008. Although the market as a whole declined and experienced record volatility during the same period, small-cap stocks suffered disproportionately.

The market overreacted and punished the small-cap sector indiscriminately. The selloff in late 2018 was so severe it drove down the valuations of companies in the sector to their lowest levels in six years. Although larger-cap stocks were not immune from the tergiversations and declines that plagued the overall market, the decline for the small-cap sector far exceeded that of its larger counterpart in the S&P 500.

After the bloodletting of late 2018, the sector now looks favorable relative to the S&P 500. According to Refinitiv, a financial data company, many analysts are anticipating companies in the Russell 2000 will collectively log double-digit profit gains throughout 2019 that will far outpace the larger-cap companies within the S&P 500. Profit projection for S&P 500 companies have been drastically pared back by analysts from their earlier double-digit expectations.

Based on a 12.6% earnings growth rate small-cap companies were expected to show during the last quarter of 2018, sector-wide profits are expected to increase by approximately 16% for the first quarter of 2019. By comparison, due to near unanimous reduced profit projections by analysts, the S&P 500 is projected to increase earnings by approximately 6% during the first two quarters of this year.

The late 2018 small-cap selloff was especially pronounced and few companies in the sector, even those with clean balance sheets and stable earnings, were spared. Due to the severity of the decline, current valuations of many small companies present auspiciously cheap buying opportunities for enterprising investors, who can now acquire stable companies at a hefty discount.

Some of the same factors that were responsible for the small-cap companies’ meteoric rise since 2016 are now back in play. As the global economy starts to slow, S&P 500 companies must contend with slowdowns in Asia and Europe as well as higher costs from converting overseas sales in the face of a strong U.S. dollar. Investors fear the continuing trade spat with China, lower projected corporate earnings for 2019 and dissipation of the benefits of last year’s tax cuts will have a greater impact on larger-cap companies.

Since investors remain indifferent to inordinately depressed valuations, bargains abound. Shares of small companies sold in late December at their lowest valuations in six years. According to FactSet, multiples for the S&P 600 Small Cap Index reached a low of 13.4 times projected earnings over the next 12 months, down from 18 times projected earnings since the end of August and similar to valuations reached at the end of 2012.

Since the state of the economy, the likely direction of the yield curve and the status of the trade dispute with China will all have an indeterminate spillover effect across the broad market, including shares of Russell 2000 companies, investors who engage in small-cap bargain basement shopping need to be cognizant of these macro risks. In this regard, it is important to note many investors have piled into cash and cash equivalents since the market turbulence began in late October.

Since Apple (NASDAQ:AAPL) announced its first-quarter revenue projections would come in far below security analysts’ expectations due to a slowing Chinese economy, the Russell 2000 index was caught in the vortex and dropped alongside the broader market. However, the drop was temporary and the sector rebounded shortly thereafter.

Although small-cap valuations appear attractive, investors should be aware the economy is exhibiting mixed and, in some cases, conflicting signals as to the strength of the current recovery.

Given the uncertainty concerning the direction of the economy for the near to intermediate term, enterprising investors should heed the counsel of Benjamin Graham and purchase these attractively priced issues for the long term.

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