The Case for Investing in Small and Midsize Stocks: A Bargain Opportunity for Savvy Investors
Smaller stocks offer relative bargains and historical outperformance, making them an attractive addition to investment portfolios.
In the world of investing, large-company U.S. stocks have been dominating the market, leaving their smaller counterparts in the dust. However, experts are now suggesting that it may be time for investors to consider diversifying their portfolios by adding smaller stocks. These stocks, categorized as small- and midsize-company stocks, present two compelling factors that make them worth considering. Firstly, due to the surge in demand for large-cap stocks, smaller stocks are currently available at relatively lower prices. Secondly, historical data shows that smaller stocks tend to outperform larger stocks over extended periods. With these factors in mind, financial professionals are advocating for investors to seize the opportunity to invest in small- and mid-caps.
The Appeal of Bargain Prices
When financial professionals refer to investments being “cheap” or “bargain-priced,” they are typically referring to the valuation of an asset. One commonly used valuation metric for stocks is the price-to-earnings (P/E) ratio, which compares a company’s share price to its earnings per share. A higher P/E ratio indicates that investors are paying more for a smaller portion of a company’s earnings. Currently, stocks in the S&P small- and mid-cap indexes are trading at approximately 14 times estimated earnings for 2024, while the S&P 500 has a ratio of around 20. This means that small- and mid-caps are trading at a discount of approximately 30% compared to large-caps. Moreover, when comparing these stocks to their historical averages, midsize stocks are trading at a 14% discount, while small-company stocks are trading at a 19% discount. According to Sam Stovall, CFRA’s chief investment strategist, this spells “relative attractiveness” for smaller stocks compared to their larger counterparts. It suggests that either large-caps are overpriced or smaller stocks are undervalued, or possibly a combination of both. By investing in smaller stocks now, investors position themselves to benefit when valuations revert to their historical means.
Historical Outperformance
In addition to the relative bargains offered by smaller stocks, historical data supports the notion that these stocks tend to outperform larger stocks over the long term. While large-caps may be the darlings of index funds and popular among amateur traders and investment analysts, small- and mid-caps have a track record of delivering superior returns. Over the past five years, the S&P 500, consisting of large-cap stocks, has returned an annualized 13.6%. In comparison, the S&P Mid-Cap 400 has returned 9.7%, and the S&P Small-Cap 600 has returned 7.7%. This trend is not limited to recent years; throughout market history, smaller stocks have consistently outperformed their larger counterparts over extended periods. This historical outperformance adds weight to the argument for diversifying portfolios by including small- and mid-caps.
The Benefits of Diversification
Diversification is a fundamental principle of investment strategy, aimed at reducing risk by spreading investments across different asset classes. By including smaller stocks in a portfolio dominated by large-caps, investors can potentially enhance their returns and mitigate risk. Small- and mid-caps often have different risk profiles and growth potential compared to large-caps. These smaller companies may be more nimble, offering greater growth opportunities, while large-caps may provide stability and consistent dividends. By diversifying across different market segments, investors can benefit from the unique characteristics and potential of both large and small stocks, creating a more balanced and resilient portfolio.
Expert Insights
Experts in the field of wealth management and investment strategy echo the sentiment that now is an opportune time to consider diversifying into small- and mid-caps. Greg Marcus, managing director at UBS Private Wealth Management, emphasizes the current favorable conditions for investing in smaller stocks. With large-caps experiencing a surge in demand and smaller stocks trading at relative discounts, Marcus believes it is a fantastic time to diversify portfolios. He highlights the potential for long-term outperformance and the opportunity to capitalize on the reversion of valuations to historical norms.
Conclusion:
As large-company U.S. stocks continue to dominate the market, investors may be missing out on the potential benefits of diversifying their portfolios with smaller stocks. With small- and midsize-company stocks currently available at relative bargains and a historical track record of outperformance, investors have a compelling case to explore the world of small- and mid-caps. By seizing this opportunity, investors can position themselves for potential long-term gains and enhance the diversification and resilience of their portfolios. As with any investment decision, it is essential to conduct thorough research and consult with financial professionals to ensure alignment with individual investment goals and risk tolerance.