Small-cap stocks are having a very strong 2021 so far. Through the first two months of the new year, small-caps have been outperforming large-caps by the largest margin in over two decades. And when I say large margin, I mean really large margin – year-to-date through March 16, small-caps have outperformed large-caps by 15%.1

There is plenty of historical data suggesting that over long periods, small-cap stocks tend to edge out large-caps on an annualized basis. It’s usually referred to as the “size effect,” and tends to be narrow but still meaningful over time. So, while small-caps’ recent outperformance over large-caps is nothing new, the sheer size of the outperformance gap is worth noting and asking a few questions about.

First, is there a reason for this outperformance?

I think one reason for the outperformance is tied to the ‘value-over-growth’ theme I’ve written about recently. Small-cap stocks are currently closer to the value end of the spectrum than large-cap stocks. If we define value stocks as having low price to per-share book value ratios relative to their growth counterparts, then small-caps are looking like the value in the current environment while large- and mega-caps are looking like growth stocks.

The price to per-share book value ratio of the Russell Top 50 Mega-Cap Index is 5.7x (through the end of February), the Russell 1000 Index (largest 1,000 stocks) is 4.2x, and the Russell 2000 Index (small caps) is 2.5x. Investors can find value in small-caps.

One of the reasons for the rotation from growth to value is mean reversion. Since 2007, the outperformance of growth relative to value has approached levels not seen since the 1930s and the dot com bubble. In fact, the spread between the price-to-earnings (P/E) ratio on growth and the P/E ratio on value stocks is the highest it has been since 2000, when the bubble burst on many growth names.2 This makes value stocks look attractive relative to growth stocks, which again has been a tailwind for small-caps, in my view.

Another value-oriented benefit for small caps: rising interest rates and the possibility of inflation. Expectations of higher inflation tend to push long-term interest rates higher, which has been impacting areas of the market with relatively high P/E ratios (i.e., growth). This could mean a reality check for many high-flying technology and other growth names, and could trigger an investor rotation into value, benefiting small-caps in the process.

One final reason for small-caps doing well, in my view – we’re in the early days of a new economic expansion and bull market. The stock market has been signaling a strong economic recovery in the months ahead, and small-cap stocks have historically done well early in a new cycle when liquidity is cheap and overall growth rates are faster. There is no way of knowing how long this initial surge could last, but I like small-cap exposure as part of a broadly diversified equity portfolio right now.

At Zacks Investment Management, our Small-Cap Equity Strategy screens all 2000 stocks in the Russell 2000 Small-Cap Index, and we access the power of our own industry-leading research firm to construct a portfolio of about 100 stocks. Our research process and data-driven decision-making means that if any one of the stocks exhibits declining fundamentals, we’ll sell it.

Bottom Line for Investors

Small-caps have had a strong run relative to large-cap stocks, particularly within the value vs. growth realm. While no one can know for sure how long the outperformance might last, I think carefully selected small-cap stocks can be beneficial as part of a broadly diversified portfolio of equities (assuming your goals and risk tolerance allow for it). I also think this economic expansion has plenty of room to run, and small-caps could benefit from rapid growth in the early phases. The Zacks Small-Cap Equity Strategy is an option to consider when positioning for this potential growth.

Disclosure

1 Wall Street Journal. March 6, 2021. https://www.wsj.com/articles/how-to-understand-the-small-stock-rally-11615026601?mod=djemMoneyBeat_us

2 Forbes. November 12, 2020. https://www.forbes.com/advisor/investing/value-vs-growth-stocks-performance/

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