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Small-Cap Stocks Look Cheap – Is Now a Good Time to Buy?

Small-Cap Stocks Look Cheap – Is Now a Good Time to Buy?

Tourists visit the Wall Street Bull statue in the Financial District

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The largest companies have dominated stock market returns in recent years, led by a handful of tech giants that have become known as the “Magnificent Seven.” The large-cap-focused Russell 1000 index has risen more than 14 percent so far in 2024 through the end of June, while the small-cap Russell 2000 index has risen less than 2 percent over the same period.

The anomalous performance has left small-cap stocks trading at a significant discount to large-cap stocks, leading some investors to see this as an opportunity to buy an undervalued investment.

Small-cap versus large-cap performance

Large-cap stocks have significantly outperformed small-cap stocks in recent years, as tech giants like Nvidia and Microsoft have seen their shares soar on strong earnings and optimism about the potential of artificial intelligence.

This is how the performance is distributed:

Russel 1000 Russel 2000
Please note: Performance up to and including 28-06-2024
YTD (up to June 2024) 14.2 percent 1.7 percent
1 year 23.9 percent 10.0 percent
3 years 8.7 percent -2.6 percent
5 years 14.6 percent 6.9 percent
10 years 12.5 percent 7.0 percent

Discount on small caps

According to Yardeni Research, large-cap stocks are trading at a forward price-earnings ratio of about 21 as of June 28, compared with about 14 for small-cap stocks, the widest gap since the tech bubble of the late 1990s. Small-cap stocks significantly outperformed large-cap stocks in the aftermath of the tech bubble and in the run-up to the 2008 financial crisis.

Some investors think potential rate cuts by the Federal Reserve could boost small-cap stocks, which tend to be more economically sensitive than large caps and more dependent on external financing. But an improved earnings outlook for small-cap stocks could also close the gap.

“Small-cap earnings have disappointed over the past year, falling more than 10 percent in 2023, while large-cap earnings, led by the Magnificent 7, have been robustly positive,” said Francis Gannon, co-chief investment officer at Royce Investment Partners. “We expect this dynamic to reverse later this year as small-cap earnings continue to recover via back-end loaded growth in 2024 and into 2025.”

Small caps can also benefit from AI

Large-cap stocks have benefited from the excitement surrounding artificial intelligence (AI), with companies like Nvidia, Microsoft, Alphabet and Meta spending billions of dollars to expand their AI capabilities, an investment that can be prohibitively expensive for smaller companies. But Gannon still sees opportunities for small caps to benefit from the rise of AI.

“As is often the case with new technologies, small-cap companies tend to fester on the back of the megatrend,” Gannon says. “Nevertheless, they will be meaningful players because they provide — or will eventually provide — many of the products and services that will support the buildout of a massive AI infrastructure.”

David Sekera, chief U.S. market strategist at Morningstar, sees an opportunity for investors to exit the big AI winners, which he says are trading at full or higher valuations.

“Given that AI stocks are generally fairly valued at best and overvalued at worst, we see much better opportunities elsewhere in the market,” Sekera wrote in a recent market commentary. “We continue to advocate an underweight position in large-cap stocks in favor of an overweight in small-cap stocks and a slight overweight in mid-cap stocks.”

How to Add Small-Cap Stocks to Your Portfolio

Small-cap stocks can be positioned for a streak of outperformance after multiple years of lagging large-cap averages. If you’re interested in adding small-cap stocks to your portfolio, you have a few options to choose from. You can choose to select individual small-cap stocks that you think will do well, or you can opt for an ETF that contains a basket of small-cap stocks.

Check out Bankrate’s list of the best small-cap ETFs.

If you already have a small-cap allocation in your portfolio, it may also be a good time to rebalance or even increase the percentage you have in small-cap stocks. Large caps have dominated the market in recent years, but small caps may be poised to bounce back in the near future.

Editorial Disclaimer: All investors are advised to conduct their own independent research on investment strategies before making any investment decision. In addition, investors are cautioned that past investment product performance is no guarantee of future price increases.