Posted by on Dec 5, 2016 in Articles & Advice, Blog, Columns, Featured |

Image Credit: Christophe Vorlet

By Jason Zweig |  Dec. 2, 2016 11:43 am ET

When markets go way up, your enthusiasm should go down.

But there may still be at least a little opportunity in small stocks, which remain less expensive than their bigger brethren. In today’s market, with stocks teetering near all-time records, being a little less overpriced than the rest is about as good as it gets.

Small stocks had a huge move in November, rising more than 11% in a month when large stocks went up less than 4%. Nearly all that gain came between the election and Thanksgiving, as investors bet that small companies, which tend to be less reliant on exports than big global firms, would benefit disproportionately from Donald Trump’s policies.

But the end of November and beginning of December have been dark for smaller stocks, which have fallen more than 2% since Nov. 25 even as large companies dropped less than 1%.

The decline since late November hasn’t been nearly steep enough to turn small companies — those with a total stock market value of a few hundred million to a few billion dollars — into big bargains. But they aren’t dangerously overheated, either.

According to Nili Gilbert and Stuart Kaye, portfolio managers at Matarin Capital Management in Stamford, Conn., small stocks are trading at 10.8 times the cash that their underlying businesses generate from operations, or slightly above their average since 1994. Big companies are valued even more richly, at 11.7 times their operating cash flow, also higher than their average over the past two decades.

The gap between those ratios is barely wider than normal, suggesting that small stocks remain relatively cheap even after their explosive rise in November, say Ms. Gilbert and Mr. Kaye.

That still won’t make them easy to own. Small stocks have long tended to fluctuate more sharply than larger companies’ shares. They also are more sensitive to many of the Trump policy proposals, so their recently heightened volatility could turn out to be only a foretaste of what is to come.

Last month’s big gap in returns between stocks of different size wasn’t unusual by historical standards. On average, since 1979, the monthly returns of small and large stocks have differed by at least five percentage points roughly once a year, says Marlena Lee, a vice president for research at Dimensional Fund Advisors of Austin, Texas, which manages approximately $445 billion.

But, as always, hot performance attracts hot money. At iShares, the largest manager of exchange-traded funds, $10 billion of new money came into U.S.-listed ETFs specializing in small stocks during November alone, says Dorothy Lariviere, an analyst and product consultant at the firm.

Just in the three weeks after Election Day, says David Santschi of TrimTabs Investment Research, the assets of all U.S. small-stock ETFs grew by 7% from new money alone. Such a flood of buying by itchy-fingered traders could introduce even more volatility; the last to arrive at the party are often the first to leave in a panic.

But the long-term case for holding smaller stocks is probably still strong.

“The market is saying that there’s been a change to the way government and policymakers are likely to interact with the real economy,” says Henry Ellenbogen, portfolio manager of the $16.3 billion T. Rowe Price New Horizons Fund.

“So investors need to revisit what they’re doing,” he says, “and change their assumptions on what’s going to drive returns.”

It’s rare for small stocks to do well at the end, rather than the beginning, of an economic expansion — which has been underway for more than seven years at this point.

But smaller companies should benefit even more than large ones, argues Mr. Ellenbogen, as the Trump administration tries to achieve faster economic growth, higher inflation, lower corporate tax rates, a strong dollar and greater emphasis on domestic production.

Furthermore, small stocks badly lagged their larger brethren in 2014 and 2015. So, even after their torrid performance in November, the returns on both the Russell 2000 and the S&P SmallCap 600 indexes still trail the giants of the S&P 500 over the past three years.

What if the market as a whole rethinks its euphoria over the election? Small stocks would suffer, too.

From late 2008 through early 2009, in the depths of the financial crisis, the Russell 2000 and the S&P SmallCap 600 indexes each dropped 30% as the S&P 500 fell 27%, according to iShares. During the 2001 recession, the same benchmarks outperformed the S&P 500 by five to nine percentage points.

The prospects of getting high returns from small stocks are somewhat lower than usual. But the risks of getting shaken out of owning them are higher than normal. Sticking with small stocks is going to take big courage.

Source: The Wall Street Journal, http://blogs.wsj.com/moneybeat/2016/12/02/the-reasons-to-appreciate-small-stocks-now/

Related podcast: http://www.wsj.com/podcasts/italy-no-vote-small-stocks/7D46382F-D61E-4EDB-9DC3-87242CCE4F03.html

Resources: Historical data on small stocks, from Ken French’s data library