Smaller capitalised - or small cap - stocks often make up a fraction of a trader's portfolio. Some traders believe they can be high-risk, hard to sell and overly focused on a particular sector. And in relation to a passive strategy, the Russell 2000 is the instrument on which a lot of these US small cap stocks are indexed.
However, the US small cap market is a deep market that contains established brands and innovative companies. For traders who know which ones to pick, small cap stocks’ low valuations could represent something of a bargain.
Of course, there are risks. In the UK, one of the biggest stories of the last decade is Neil Woodford's fall from grace. Woodford's flagship came a cropper due to his investments in smaller cap stocks that were hard to sell when investors wanted to pull money out.
But after a summer sell-off and a cool down in recession fears, US small caps might be an attractive option for bargain hunting investors.
Why invest in US small caps?
US small caps as an asset class are frequently characterised as high risk start-ups, overly focused on technology and often loss making. However, the reality is somewhat different.
Many of these companies have existed for decades, across a wide group of industries. Small cap businesses tend to be less globalized and more domestically focused.
In theory, that means macroeconomic issues that have weighed down larger capitalised companies are less of an issue, although the US-China trade war saw the Russell 2000 - the index US small caps trade on - lose 5.1% in value over August.
How has the Russell 2000 performed?
Over a 12 month period, the Rusell 2000 is up 6.15%, having nearly made up August's losses. The iShares Russell 2000 ETF, the biggest fund that tracks small caps, is also up over 6% in the same period.
The Financial Times reports that in the week ending 6 September $1.5 billion flowed into the ETF - its largest week in a year. This came after the last week of August saw inflows which drew a line under the net outflows the fund had been experiencing since early 2008.
Investors had been selling positions in defensive stocks and piling into safe havens like US treasuries. But as recession fears ease, the low valuation of small caps is again attracting investors.
“They’re down on their butts,” said Steven DeSanctis, equity strategist at Jefferies. “But you get a bit of positive reprieve around growth globally and no recession for the US, and [small-caps] are going to do well.”
Why do the Fed rate cuts help small caps?
In July the Federal Reserve made its first interest rate cut since the financial crisis in 2008. According to Jefferies, small cap stocks typically perform better in a rate cutting environment. In the past 60 years, these stocks have gained 28% on average in the 12 months after the Federal Reserve begins to cut rates. Large caps, on the other hand, gained 15%.
Small caps fare better when rates are cut as small business owners tend to secure funding through adjustable-rate bank loans. Bigger businesses are more likely to be on fixed-rate deals. With the Federal Reserve now cutting interest rates to stimulate the US economy, small cap stocks could start to climb.
Time to buy US small caps?
The resurgence in small caps could continue if the Fed continues to cut rates. The US and China agreeing a way out of the current trade spat will also provide a more stable economic outlook. Analysts will be closely watching when the two countries meet in November.
However, low interest rates and valuations will only go so far. For the Russell 2000 to climb back to last August's high will take strong earnings results and a growing economy. As Craig Stone, small-cap portfolio manager at Kayne Anderson Rudnick says:
"At the end of the day, earnings growth drives returns and we do have to have a better economy for that to happen."
Disclaimer Past performance is not a reliable indicator of future results.
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