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Stocks  | January 17, 2020

Buy small-caps if you think the economy will keep humming, but stick with higher-quality, defensive stocks, just in case.

Investors who expect 2020 to be a year of solid economic growth should consider small-cap stocks, according to Scott Opsal, director of research and equities at Leuthold Group. In a note published Wednesday, Opsal argues that small-caps should do well in a period of higher inflation and appetite for riskier assets.

But it may pay to tamp down risk in small-caps by adding a quality factor that could enhance returns, compared with the broader small-cap universe.

Will small-caps finally have their day in the sun? There is reason to be skeptical they will finally start to beat large-caps. Small-caps have underperformed large-cap stocks for more than a decade. The iShares Russell 2000 exchange-traded fund (ticker: IWM) has returned an annualized 11.7% versus a 13.2% annualized gain for the SPDR S&P 500 ETF (SPY) over the past 10 years. Go back 15 years—before the bear market of 2008-09—and the results are similar: The iShares ETF has gained an annualized 8.3% versus 9.2% for the S&P 500 ETF. Investors in the S&P 500 ETF would be ahead by 273 percentage points versus 230 points in the iShares ETF (including price gains and dividends).

Large-caps appear to be benefiting from a number of structural and economic advantages. Giant multinationals and other large companies have done a better at managing costs, outsourcing and running leaner operations, according to Opsal. And they have captured more pricing power because of dominant market positions, oligopolies, and innovation, enabling them to defend prices and improve margins.

Large-caps are also clinging to earnings growth. Large-cap stocks maintained small gains in net income in 2019, Opsal writes, while small-caps fell into negative territory. “If 2020 should prove difficult for earnings growth, we would expect large-caps to maintain their earnings growth superiority.”

Investors tempted by the low valuations of small-caps should also consider the reasons they look cheap (versus large-caps). Net margins for large-caps have pulled away from small-caps, Opsal writes. Margins for large-caps jumped to nearly 12% from around 4% since the early 1990s, while small-cap margins remain stuck below 6%.

There are also many more “zombies” in the small-cap universe—unprofitable companies that soldier on like the walking dead. Nearly 35% of small-caps are unprofitable compared with 5% of companies in the S&P 500, he writes. The small-caps “are among the walking dead only because credit markets continue to extend very lenient credit terms to marginal businesses.” If credit tightens, he says, small-caps could be hit hard.

Nonetheless, Opsal writes that small-cap may still be a good bet. The stocks could outperform if the economy gathers steam, inflation picks up, and appetite for risk improves. And applying some quality criteria could boost returns over the broader small-cap universe (such as the Russell 2000 index).

Criteria for inclusion in the S&P 600 Small Cap index, for example, includes at least four prior quarters of positive earnings, stocks with a market cap of at least $600 million (avoiding the riskier, microcaps), and a public float of at least $300 million.

History suggests higher-quality small-caps perform better than the broader small-cap universe. The iShares Core S&P Small Cap ETF (IJR) tracks the S&P 600 index. The ETF has gained an annualized 9.4% over the past 15 years, beating both the SPDR S&P 500 ETF (at 9.2%) and the iShares Russell 2000 ETF (8.3%).

Small-caps aren’t likely to outperform large-caps in a bear market or an economic downturn. But at least the quality small stocks are likely to hold up better than weaker cousins in the indexes. And if the economy keeps improving, the quality stocks could outperform.

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