- Bank of America believes small caps will beat the broader market significantly in the next decade.
- The firm’s head of US small- and mid-cap strategy made a strong case for the group.
- Here’s how investors can take advantage of a big rally for smaller stocks.
Small caps have outperformed their larger peers lately, and there’s reason to believe the trend will continue for the next 10 years, according to Bank of America.
“If you buy small caps today based on current valuations, the annualized returns for small caps over the next decade could be in excess of 10%,” said Jill Carey Hall, the firm’s head of US small- and mid-cap strategy at Bank of America, in a recent interview with Insider.
Hall continued: “Whereas for large caps, the same framework would suggest about half of that. The S&P 500 could only see about 5% annualized price returns over the next decade.”
The bull case for overlooked small caps
Both valuations and equity flows suggest that small caps are the market’s best-kept secret right now.
Smaller companies remain historically cheap compared to large caps, Hall said. The most widely followed US small-cap index, the Russell 2000, is trading at a forward price-to-earnings (P/E) ratio of 13x to 14x, which Hall noted is below its long-term average multiple of about 15x.
“Valuations don’t always tell you a lot about what’s going to happen to the market over the next few months or even the next year, but they do tend to be very predictive about what happens over the long term or the next decade,” Hall said. “So definitely for long-term investors, we think this is a great opportunity to overweight small caps.”
Small-cap skeptics will rightly point out that the group tends to underperform in recessions, and that Bank of America itself is calling for a downturn this year. Hall acknowledged that concern but noted that unlike large caps, small caps have already factored in economic weakness.
“Even after the rally we’ve seen, we’re still seeing that small caps are really the only segment that’s pricing in a recession,” Hall said. “And we’ve definitely seen a lot more optimism on small caps by investors that we meet with, but the money hasn’t really moved yet.”
Although Bank of America data shows that its clients bought small caps in aggregate in 2022 by the largest amount since 2015, Hall said that the group remains unloved, given that it saw net outflows in five of the previous six years. Flows to small caps have been negative again in 2023 despite their strong start, according to the firm, though the group did see inflows last week.
“When we looked at large-cap fund manager holdings, they’ve generally been overweight a lot of the mega caps, underweight the smallest stocks,” Hall said. “So you’ve definitely seen a bias toward mega caps and larger stocks for many years.”
Besides attractive valuations and weak inflows, Hall listed a few fundamental catalysts that should disproportionately benefit US small caps, including resilient services spending and corporate capital expenditures on automation and supply chains.
4 ways to bet on a decade-long rally for small caps
Investors targeting small caps would be wise to consider a mix of stocks across both cyclical and defensive sectors, along with quality companies with high levels of free cash flow, Hall said.
Her current preferences are energy, financials, industrials, and consumer staples. The first three are economically sensitive, while staples tend to hold up better in economic downturns.
Energy and financials screen well since Hall said they’re generally high quality and low beta, meaning that they’re less volatile than the broader market. Energy small caps are underowned by fund managers and should keep performing well while oil prices remain elevated, Hall said. She added that financials, including regional banks, have way better balance sheets and more stable earnings than they did during the depths of the financial crisis.
Meanwhile, industrials tied to automation make sense, while staples are a safer defensive bet than small-cap healthcare names, which Hall said have deteriorated in quality very quickly.
Lastly, Hall said that while value-oriented small caps look more appealing than growthier names as a whole, the valuation gap between the two is much closer than it was a year or two ago.