Small caps are invaluable for your portfolio

It might be time to start shopping “down market”, says Jennifer Hughes in the Financial Times . The Russell 2000 index of US small and mid-sized firms has been having a miserable year, gaining less than 1% even as the large-cap S&P 500 soars 17.5%.

Over six months, “ small caps have only underperformed their bigger cousins this badly at two other points since the 2000 dotcom boom”. While mega caps rocket due to artificial intelligence fever – Nvidia alone is now “worth roughly as much as the entire Russell 2000” – struggling small caps suggest that the wider American economy is lethargic.

US small caps and mid caps have generally under-performed US large caps over the past 10 years, says J.P.Morgan’s Sitara Sundar. They are thus trading “at a near record valuation discount” to their large-cap peers. US small and mid-caps are at “the leading edge of innovation”, whether in software or advances in industrial automation. But small and mid caps vary in quality.

For every exciting small cap, there are ones that “carry high levels of debt or do not generate earnings”, so “active stock picking” is key. Some investors buy small companies in pursuit of the “small-cap premium”, says Ben Carlson on his A Wealth of Common Sense blog. Between 1926 and 2021, US small-cap stocks outperformed large-cap stocks by more than 10%.

“Others dispute whether the premium is real, but whatever the truth, small caps are invaluable as a portfolio diversifier”. That’s especially true in periods like today where large-cap valuations are vulnerable to a reversal.

“The last time small caps lagged in a big way was the late 1990s when the dotcom bubble went into hyperdrive”. When the bubble burst, it was the undervalued small caps that “outperformed in a big way during the next cycle”.

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