The Case for the S&P 600

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Hi, Jackson here, the audio producer for the Barron's Streetwise podcast. This week we're revisiting an episode that aired in December on small-cap stocks that continues to be relevant today. We spoke with Jill Carey Hall at BofA Securities and Quy Nguyen at Research Affiliates, and they both said small-cap stocks are poised to outperform large-cap stocks over the next decade by a lot. For the next 10 years, BofA sees 12% yearly returns for small caps, which is 5 points more than it sees for large caps. Though I'll note here that since this episode was published, large caps have continued the trend of outperforming small caps. The S&P 500 index is down about 3% since then, while the small-cap S&P 600 is down about 6% and the small-cap Russell 2000 is down 9%. Still, just last week, Jill from B of A Securities wrote that history suggests small caps could outperform large caps by 4 percentage points over the next 10 years. Within small caps, energy, financials, and real estate screened broadly as the most undervalued versus history. We'll be back next week with a regular episode.

Small caps right now are trading at what we view as a very attractive historic opportunity for valuations, both on an absolute basis and, and on a relative basis versus large caps.

Hello and welcome to the Barron's Streetwise Podcast. I'm Jack Howe, and the voice you just heard That's Jill Carey Hall. She's the head of small and mid-cap strategies at B of A Securities, and she says that at the moment, shares of small companies are poised to outperform. And Jill is not alone in that view. Coming up, we'll examine the case for small caps, and we'll talk about the best ways to invest. Listening in is our audio producer, Jackson. Hi, Jackson.

Hi, Jack.

This is not really the podcast friendliest of topics, I don't think. I mean, it's a little abstract. Small companies, right?

Small caps. Well, in Gen Z TikTok parlance, to cap is to exaggerate. So no cap means I'm not exaggerating.

No cap. Mid caps, small caps, even micro caps. But no caps are new to me.

I think it's just singular, no cap.

No cap. All right, good. I always like a historical backstory, but we can't point to like Zachariah Small who invented the small cap or anything like that. It's just companies that are not as big as the others and it's an arbitrary cutoff, right? Because the value of the market changes over time. So how small is small? If you look at the Russell 2000 index, that's smaller companies. The median market cap there is $1 billion, and the top market cap is $13 billion. So somewhere in that range. And when I say market cap, I mean capitalization. That's the share price times the number of shares outstanding. It's how much you would have to pay to buy all the shares. How are we doing so far, Jackson?

I think Zachariah Small would be proud.

Okay, well, look, I will tell you, I guess, a little bit of a historical note here. Decades ago, market researchers documented this thing that's come to be known as the small-cap effect. That's the tendency of small companies to produce higher average returns than large ones over long time periods. And the theory behind it was that small companies are risky, so the extra return must be compensating investors for taking the extra risk. But they haven't looked like that lately for a couple of reasons. First of all, large cap companies have been beating small cap companies for a long time. The Russell 1000, those are big companies, that's beaten the Russell 2000 by 3 points a year over the past decade. The large caps returned an average of 12.8%. It's been all about the bigs. For a decade. The other thing is small caps have actually been less volatile than large caps during periods of market stress. They did relatively well during something called the taper tantrum back in 2013. That's when the Fed kind of hinted about dialing back its bond purchases and investors turned cranky. Small caps did all right then. During the UK's Brexit referendum in 2016. Small caps held up well then. They also did during the COVID-19 pandemic. So that's the opposite of what investors would expect from risky stocks, which is what small caps were supposed to be. There is a lively debate now over whether the small cap effect is dead or just asleep, or even whether it truly existed to begin with and we can leave That debate aside, we don't need it for what we're going to talk about now. Leave that one to the academics. Our only interest here is whether small caps are unusually cheap, and they are, although depending on where you look, you might not see it at first glance.

And then when you look at the, the relative multiple of small versus large caps, they're trading at about a 30% discount to where they usually trade historically.

A 30% discount sounds cheap to me. That's Jill Carey Hall. Again, she's the head of small-cap strategy at B of A Securities. I mentioned earlier that the Russell 2000 is a small-cap index. It trades pretty close to 20 times earnings. That's actually a smidgen above its long-term average, and that is no one's idea, I would think, of deep value territory. So what does Jill mean when she says that small caps are trading at a big discount? She means that they look cheap once you weed out the unprofitable ones.

One of the challenges of looking at the index and the data is that, you know, when you look at it on a price-to-earnings ratio, a lot of small caps don't have earnings. These are smaller stocks that a lot of them aren't profitable. So about a third of the companies in the index actually don't have profits.

If you take the Russell 2000 and you remove the unprofitable companies and a handful of statistical outliers, the price-to-earnings ratio for the index drops to about 12 versus a long-term average of 15. I know that sounds like statistical cherry-picking, but adjusting for profitability is important for two reasons. One of them is that 33% of the Russell 2000 members today have negative earnings. That's up from 20% a decade ago, and it's a record high. One industry is more responsible for that than the others.

Biotech has become much lower quality over time. You know, few of those stocks are profitable. You have a lot more earlier stage biotech companies that have come to market. You know, we saw an IPO boom in 2020, 2021. And, you know, that's an area of small caps that we're more cautious on.

There's a second and even better reason to exclude unprofitable companies when you're sizing up the Russell 2000. The adjusted P/E ratio has been a better predictor of future returns than the unadjusted one. That's based on a BofA analysis of data going back to 1985. Right now, that adjusted P/E leads BofA to predict 12% yearly returns for small caps over the coming decade. That's 5 points more than it predicts for large caps.

Really, the only other time small caps were this cheap versus large caps was briefly during the tech bubble period. So '99 to '01, and that ended up being a great time to buy small caps because if you look at, you know, from March '99 over the next 7 to 8 years, small caps were up about 100% and large caps were flat.

There's more to like about small caps than their cheapness.

A lot of these companies are, are more domestic. They're well positioned to benefit from some of the multi-year trends that we see right now, reshoring of US manufacturing. So we, as a lot of these big large cap multinationals are bringing back their operations to the US, they're being forced to spend on, on capital expenditures and, and those CapEx cycles tend to benefit smaller stocks.

The outlook isn't entirely rosy. Small companies tend to have bigger earnings declines during recessions than big companies, and we could be on the cusp of a recession now. But Jill says that small caps are already pricing in a recession on the order of the one we saw during the global financial crisis more than 15 years ago. One way for investors to add small-cap exposure is with a low-fee index fund. You could pick one that tracks that Russell 2000 index, but I think it's an upgrade if you switch to one that tracks the S&P SmallCap 600 index. That index has actually outperformed the Russell 2000 by more than a percentage point per year over the past 5 years and 10 years and 20 years, and it's generally been less volatile. There's a reason S&P uses a profitability screen to admit its index members. One fund option there is called SPDR S&P 600 Small Cap ETF. The ticker is SLY. Among pockets of the small-cap market, Jill prefers value to growth, and she favors the energy, financial, and consumer staples sectors.

From a sector perspective, you know, energy, financials are two areas of small caps that, that rank well in our work. We are expecting a higher-for-longer commodity price backdrop. We are expecting, you know, as quality outperforms financials, has actually become one of the highest quality sectors within small caps right now. So those are two sectors that look well positioned. Consumer staples as well as a more defensive sector within small caps as we head into a potential recession.

Jill also says that large-cap investing has become crowded because everyone is piling into S&P 500 index funds.

We've seen the ETFization of the market. We've highlighted that the, the most crowded ticker out there right now likely isn't a stock, it's the S&P 500.

Thank you, Jill. Coming up, we'll talk with another small-cap bull about the case for what's called fundamental indexing, and we'll run through a handful of stock picks from Wall Street analyst and a mutual fund manager. That's next after this quick break.

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Welcome back. If a profitability screen has helped that S&P SmallCap 600 index outperform its rival, the Russell 2000, would a value tilt help even more? Those indexes both weight small caps by market value. In other words, the biggest smalls get the most weight. Jackson, does that make sense?

Did you say biggest smalls or biggie smalls?

Now I forget. Asset manager Research Affiliates has indexes that weight companies a different way, by fundamental measures of value like sales and cash flow and dividends. Charles Schwab, for one, sells a fund that uses a Research Affiliates index. It's called Schwab Fundamental U.S. Small Company Index ETF, and the ticker there is F NDA, like fudgesicle, nonsensical, dune buggy, aromatic. It's a smidgen more expensive than the other funds, but it's still cheap with yearly expenses of a quarter point. Since inception in 2013, the fund has beaten the Russell 2000 by nearly a point. Quay Nguyen, she's the Chief Investment Officer of Equity Strategies at Research Affiliates. She points to a recent long-awaited bounce for value stocks relative to growth stocks as a sign of things to come. She says that small caps, which have also underperformed for a long time, could be next.

If you really think about it, the value reversal has been a big theme this year, right? That's— everybody's seen it and everybody's looking around and saying, what's next? And in our opinion, the thing that's going to— the next shoe to drop is really small-cap versus large-cap. For people who invest in the US, most people have really noticed a significant underperformance of small-cap stocks relative to large-cap stocks over the last, you know, 7 to 10 years or so. If you look at it, small caps have typically outperformed large caps by a small amount per year, but over the last 7 to 10 years, small-cap stocks have trailed large-cap stocks cumulatively by 57% in the US.

Kueh's preferred way to invest is, as you might imagine, her firm's fundamental weighted approach, and not just for its value bias. The methodology uses some quality screens.

We'll look, for example, at sales, but we also adjust that for leverage, right? So we don't want to see— is we don't want to see a company achieve sales by just leveraging up. We look at book value, but we also adjust book value for intangibles. We want to see a company that actually has strong balance sheet because it has got both book value and intangibles.

Kueh says that screening for quality is particularly important for small caps.

A lot of these stocks that are cheap are cheap for a reason. And if you get a small-cap stock that's cheap for a reason, it has a high probability or a higher probability of just going away. With a large-cap stock that's low quality, what happens is it becomes a mid-cap stock, management strains out, and they come back, right? With a small-cap stock, A lot of times you hit that wall and you just never come back.

Like BofA, Quay has studied historical small-cap valuations to get a read on what performance is likely to look like from here. She used a different set of valuation measures in her research, but she arrived at a similar conclusion.

And what we believe is that the relative valuations between large-cap and small-cap stocks are so stretched right now that over the next 5 to 7 years, small-cap stocks could really rebound, outperforming their large-cap brethren on a global basis by, on average, 3.7% per year.

Thank you, Kawai. I promised some stock picks. Let me give you a handful taken from a Barron's Magazine story this week on small caps. The first two are value names, and they come from JP Morgan, which began tracking a model portfolio of small and mid-cap stocks in mid-July. That portfolio is off to a fast start, beating the Russell 2000 by about 13 points so far. One of JPMorgan's top small-cap picks is Boot Barn, ticker BOOT. It sells western wear and work boots. Another is steelmaker Stelco, which trades in Canada. Under the ticker STLC. It has more cash than debt and has bought back nearly 1/3 of its shares this year. Here are a couple of small-cap growth picks from Josh Spencer. He manages the T. Rowe Price New Horizons Fund. Remember, growth has done poorly as a factor this year, so these are for investors who expect growth to come back. Josh's fund ranks in the bottom 10% of its group for 1-year returns, but in the top 1% for 15-year returns, according to Morningstar. Among Josh's favorite stocks now are HubSpot, ticker HUBS, and Ceridian HCM Holdings, ticker CDAY. Both of those trade at a fairly high multiple of earnings. HubSpot competes with the much larger Salesforce in sales software, and likewise Ceridian competes with a better-known company called Workday on workforce management software. This is not a stock-picking podcast. We don't have a lightning round here. Feel free to stick with index funds, and if you already have some small-cap exposure, keep doing what you're doing. Jackson, am I missing anything?

I know there's no lightning round, but how do you feel about some thunderous applause?

Simulated praise feels pretty good. Thank you for listening. Jackson Cantrell is our producer. If you have any investing questions, just tape them on your phone, use the voice memo app, and send it to jack.hough— that's H-O-U-G-H— at barons.com. See you next week.

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