By Michael Brush
If stock market FOMO is starting to bug you, but you’re hesitant to buy stocks, here’s a fix: Go small.
Small companies are still super-cheap.
These aren’t companies whose CEOs grab headlines when they speak. You may not even have heard of most of them. But when you buy their stocks, you are investing in the economic heart and soul of the U.S. Small companies employ most people in the country. You probably work for one.
Here are three reasons why they look attractive.
1. The smaller, the better
The Russell 2000 Index /zigman2/quotes/210598147/delayed RUT +3.34% , which tracks smaller companies, recently traded at a forward price-to-earnings (P/E) of 12.4. That is 19% below its historical average (since 1985). In contrast, the Russell 1000 Index /zigman2/quotes/210598144/delayed RUI +2.12% of larger-cap names trades at a forward P/E of 17.5 times. That is 13% above its average.
Put another way, the relative forward P/E of the Russell 2000 is 0.71 time the Russell 1000 forward P/E, below its average of 1.01 times. (These data come from Bank of America researchers Jill Carey Hall and Nicolas Woods, in a note published this week.)
This value differential implies vast outperformance for small companies, say Hall and Woods. It suggests 12% annualized returns for Russell 2000 small-cap names over the next 10 years vs. 7% for the larger-cap Russell 1000 names. Small companies are generally a good place to have part of your long-term investments. Since 1926, smaller companies have posted a compound annual growth rate (CAGR) of 12% vs 10% for the S&P 500 Index /zigman2/quotes/210599714/realtime SPX +2.05% , notes William Blair economist Richard de Chazal.
But Bank of America offers this important warning: Think long term. This is not a prediction about what will happen to small stocks tomorrow, or next month.
“Valuation tends to be a poor short-term timing indicator, but it matters much more for long-term,” says the bank.
However, in my view, you may not have to wait too long for outperformance. Why? So-called smidcap — small- and mid-cap — names tend to outperform in a bull market as investors desire riskier assets, and I believe a new bull market has emerged since the mid-June lows.
Smidcaps have market values of $1 billion to $10 billion. They include the likes of Crocs /zigman2/quotes/201458716/composite CROX +4.87% and Texas Roadhouse /zigman2/quotes/207361729/composite TXRH +4.06% . Large-caps are $10 billion and up. The Russell 1000 large-cap index includes giants including Apple /zigman2/quotes/202934861/composite AAPL -1.54% , Microsoft /zigman2/quotes/207732364/composite MSFT +2.06% and Alphabet /zigman2/quotes/202490156/composite GOOGL +2.96% .
2. Investors will warm up to ‘smidcaps’
Judging by sentiment indicators, investors are clearly still not in full risk-on mode. But they’ll get there. Just give them time. Why?
Inflation is coming down, which reduces the risk that the Federal Reserve will create a recession. Besides, the economy actually looks sound. The Atlanta Fed GDPNow estimate for third-quarter GDP was moved up to 2.5% from 1.4% Aug. 10.
“We won’t be surprised if real GDP for Q1 and Q2 eventually are revised from down slightly to up slightly,” says Ed Yardeni of Yardeni Research. “This is shaping up to be a year of slow growth, but not of recession.”
As investors figure this out, they will take on more risk and buy smidcaps. That’ll drive them up. That means the time to buy them is now, before they do.