Why To Buy Small-Cap Stocks Now

The winds of a gathering recession are blowing apart the market fortunes of small-cap stocks. But there are two solaces for devotees of small companies.

First, historically, they spring back the most after a recession, cruising past the big companies overshadowing them now in stock returns. Second, somewhere among them are tomorrow’s giants. Hence, now is the time to get in, while they are beaten down and cheap. After all, a $1,000 investment in Microsoft, when it went public in 1986, would be worth $2.7 million today.

What specifically should you look at? Take AMN Healthcare Services, a hospital staffing company that has suffered amid a lack of demand for many medical professionals, other than those battling COVID-19—due to a falloff in routine doctor visits and elective surgery. Its earnings and revenue plunged in the first quarter. The stock is off 15% from its high in winter. But the aging of America should resume the company’s upward trajectory once the pandemic is over.

Ditto Diodes, a provider of the components for microchips and other necessary parts for the coming internet of things. And MDC Holdings MDC , a home builder focused on starter homes, which millennials will increasingly need. All these three (culled from analysts’ recommendations) have solid balance sheets, good management and price/earnings ratios below the market average.

At present, even as larger stocks regain ground lost the winter downdraft, small-caps are lagging badly. The stats are grim. The Russell 2000, the premier benchmark for small stocks, entered a bear market sooner this year than the big boys.

From peak to trough, January to March, the Russell slid 41%, while the large-cap S&P 500 dropped 34%. In March, small-caps had the worst performance of any other sector. They hadn’t done this badly since 1931. Thus far this year, the Russell index is down 21.4%, as the S&P 500 is off just 5.8%.

“Investors have chosen to shelter in larger, well-recognized brand name companies with perceived safety and thus shunned stocks that were under-followed, under-owned, under-appreciated,” says Nancy Prial, co-CEO at Essex Investment Management. (She did not make any of the previous stock picks for us.)

And yet, other statistics support a long-term, value-oriented view. For instance, says Prial, a student of small-caps, these stocks have not only done well after economic slumps, they have out-performed larger stocks after nine of the last 10 recessions.

That’s not all. Prial has a list of current corporate stars that were founded during past economic slumps—and went on to glory and mega-cap status. When Bill Gates and Paul Allen started Microsoft in 1975, in an Albuquerque garage, the OPEC recession was swirling. Electronic Arts EA and Adobe ADBE opened amid the 1982 downturn, and Airbnb as the 2008-09 financial crisis battered the economy.

Going back further: General Electric GE commenced in the panic of 1873, IBM IBM in the slump of 1910-1911, Walt Disney in the 1923-24 recession. In another garage in 1935, this one in Palo Alto, Bill Hewlett and David Packard hatched Hewlett-Packard HPQ , and United Technologies UTX , then called United Aircraft, got going a year earlier—both in the teeth of the Great Depression.  

What’s more, Prial compiled a roster of more recent successes, fledgling outfits that grew enormously since her firm bought stock in them, when they had less than $500 million in market value. They went on become multi-billion-dollar growth machines. These include Illumina ILMN (position acquired in 2002, genetics), Concur Technologies (2003, expense account software), Ulta Beauty ULTA (2008, cosmetics) and Novanta (2015, robotic components).

The case for small-caps was classically made by Nobel laureate Eugene Fama and fellow scholar Kenneth French in 1992, when they both were professors at the University of Chicago Booth School of Business. Their study concluded that, because small stocks had more room to grow, they outstripped others over time. Later updates backed up that finding.

It makes sense: A successful small company can triple or quintuple sales and profit over a few years, while many large-caps have matured and do well to deliver single-digit expansions.  

Certainly, numerous small-caps will fail in this recession, tumbling into bankruptcy court or even oblivion. Nonetheless, those that come out the other side will have demonstrated their mettle and investors will reward them.

Others, admittedly just a precious few, will go on to become the next Microsofts MSFT . And their stocks now are on sale.

Source: Forbes – Money