Small-company stocks are often the canaries in the market’s coal mine.
Typically defined as stocks with a market value of less than $10 billion, their prices usually peak and then decline before large-company stock prices do in anticipation of a top in the economic cycle or a rise in interest rates. Similarly, “they tend to outperform early, when it seems like the worst is behind us,” says Sam Stovall, chief investment strategist at CFRA Research.
Lately, the canaries have been quite chirpy. For the six months ended March 31, the Russell 2000, an index of small-cap stocks, gained a robust 9.1 percent. It led the S&P 500 index for part of that stretch, a good sign, given that the Russell has lagged the big-company benchmark in seven of the past 10 calendar years.
No one knows, of course, whether that trend will continue. But you have plenty of other reasons to give small-company stocks a look now.
For starters, they’re cheaper than they’ve been in decades. Analysts have a brighter outlook for small-cap earnings growth than for the rest of the market, too. And a wobbly economy means now is a prime time to buy stakes in small companies, say some experts. History shows that small-cap stocks rally before an economic rebound is clearly under way.
If you invest in small-company stocks, focus on high-quality firms that can provide some resilience in a rocky market. Here are some funds with a quality tilt that make it easy to boost your exposure to small-company stocks.
Avantis U.S. Small Cap Value ETF. Only highly profitable small companies trading at a bargain price are considered for this low-cost, actively man-aged exchange-traded fund, run by four managers. “If a company is cheap with high profits,” says co-manager Mitchell Firestein, “it’s going to generate a higher expected return.”
Dimensional U.S. Small Cap Value ETF. At Dimensional Fund Advisors, any company in the bottom 10 percent of the U.S. stock market is considered small. Within that universe, the managers ferret out the firms that are profitable and that trade at a low price-to-book-value ratio. The process yields a portfolio of 900-odd stocks, with no single stock accounting for more than 1 percent of assets.
iShares Core S&P Small-Cap ETF. This fund tracks the S&P SmallCap 600 index. That’s our preferred benchmark of small-company stocks, too, in part because it skews toward higher-quality firms—companies must have posted profits for at least the past 12 months to be considered for inclusion in the index.
Mesirow Small Company. At Mesirow, profits matter—or profitability expected within the next 12 to 18 months. Price matters, too. Plus, prospective stocks must have catalysts to power earnings and cash flow growth over the next year or so. “We marry those considerations with top-down trends and themes,” such as the growing popularity of electric vehicles, says Leo Harmon, co-lead manager of the fund. The combination of a promising stock and a favorable trend is like finding “a good house in a good neighborhood,” Harmon says.
