Are small-cap stocks overvalued?
Many see the small-cap index as
2024 may see a resurgence of small-cap stocks, challenging the recent dominance of large-cap stocks. Small caps are undervalued and well-positioned to capitalize on market trends, experts say.
2] Overvalued against other counterparts: "Small-cap stocks are overvalued compared to their larger counterparts, leading to a correction in the index," said Amit Goel.
With the economy roaring through early 2024, capitalizing on small-cap stocks would be a worthwhile move during this upswing. After a roaring 2023, with the S&P 500 up about 26% last year, we've seen a continued bullish environment to start 2024.
If you cannot tolerate seeing negative returns on your investments at specific periods, you should stay away from small-cap funds. If you cannot see such sharp ups and downs, it is better to stay away from small-cap funds. Explore investing in Large Cap Funds instead.
Analysts forecast that 2024 earnings for small-cap companies will grow faster than large-cap earnings in most regions.
We do not expect a deep or prolonged recession. Currently, all the signs are pointing to a soft landing in 2024. But, if a recession did occur, it would delay a recovery in small caps. We expect the increasingly better visibility of a soft landing to bolster the small cap recovery.
Small-cap stocks tend to offer greater returns over the long-term, but they come with greater risk compared to large-cap companies. The greatest downside to small-cap stocks is the volatility, which is greater than large-caps.
They might exaggerate—or even invent—its products or capabilities, perhaps capitalizing on current events or market trends to appeal to investors. The potential combination of minimal information and low trading volume can also make it easier for bad actors to manipulate a stock's price to their advantage.
In an analysis of foreign and U.S. investments from December 1998 through June 2023, researchers at index provider MSCI found that small-cap stocks outperformed large firms over 15-year periods about 9 in 10 times.
Will small-cap stocks ever recover?
Some investors think earnings could drive the next leg higher for small-caps. Analysts expect earnings growth among companies in the Russell 2000 to rebound to 28.2% in 2024, after an expected decline of 11.2% for 2023, according to FTSE Russell.
| Company | CMP (Rs) | Sales CAGR (3 yrs, %) |
|---|---|---|
| AMANI TRAD | 382.1 | 1,272.2% |
| BRONZE INFRA | 1.0 | 1,119.9% |
| BALU FORGE | 227.4 | 1,070.7% |
| MODERN CONVERTERS | 99.9 | 929.9% |
| Stock | 2024 return through March 31 |
|---|---|
| Janux Therapeutics Inc. (JANX) | 250.9% |
| Trump Media & Technology Group Corp. (DJT) | 254.1% |
| Super Micro Computer Inc. (SMCI) | 255.3% |
| Viking Therapeutics Inc. (VKTX) | 340.6% |
We believe that only investors with a very high risk appetite and stomach for volatility should invest in small cap schemes. They also should have a long investment horizon of, say, seven to 10 years.
A key reason for this is that small caps have struggled in the high interest rate environment more than large companies. Small caps tend to be more focused domestically with earnings growth often closely tied to how the U.S. economy is performing or sentiment about how the economy will perform.
| Investment category | Aggressive investors | Moderate investors |
|---|---|---|
| Small-cap stocks | 20% | 10% |
| International stocks | 20% | 15% |
| Emerging market stocks | 10% | 0% |
| Intermediate bonds | 10% | 30% |
We expect earnings to drive the next leg higher for small caps. According to FTSE Russell, analysts anticipate that expected earnings growth among companies in the Russell 2000 will rebound by 28.2% in 2024, after an expected decline of 11.2% in 2023. The timing depends somewhat on the ultimate path of the US economy.
| Stock | Expected Change in Stock Price* |
|---|---|
| Tesla Inc. (TSLA) | 61% |
| Mastercard Inc. (MA) | 14.2% |
| Salesforce Inc. (CRM) | 7.2% |
| Advanced Micro Devices Inc. (AMD) | 11.3% |
Equity investments require long-term horizons of preferably 3-5 years. But small-cap equity may require an even longer horizon of 5-7 years to account for periods of high volatility. A longer horizon gives you a much better chance of earning the higher returns you're taking the higher risks for.
Gannon said the explosion in small-cap shares in the fourth quarter portends well for the group in 2024, as well as for the market in general. When the equal-weighted Russell 1000 outperforms as it did the final three months of last year, small-caps typically outperform the S&P 500 by 600 basis points, he said.
What is the outlook for the small-cap?
An upbeat outlook for U.S. smaller companies
A strong jobs market with a high level of employment means U.S. wages are rising, while excess savings are also at historically high levels. Importantly, U.S. consumers are also less immediately exposed to the steep rise in interest rates than many other countries.
| Company (Ticker) | Forward P/E Ratio |
|---|---|
| Trex (TREX) | 37.2 |
| Union Pacific (UNP) | 19.2 |
| Fidelity National Information Services (FIS) | 13.8 |
| Humana (HUM) | 12.2 |
Over the past 11 recessions, small caps have beaten their larger cousins by over 16% during the 12 months after a recession started. Consider the periods before and after the dot-com crash. The S&P 500 outpaced the Russell 2000 by eight percentage points a year from 1995 to 2000.
Individual small-cap stocks offer higher growth potential, and small-cap value index funds outperform the S&P 500 in the long run. Small caps also experience higher volatility, and individual small companies are more likely to go bankrupt than large firms.
| Year | Return [%] |
|---|---|
| 2021 | 42.8 |
| 2020 | 3.8 |
| 2019 | 18.9 |
| 2018 | -12.9 |
