Five Reasons to Consider Investing in Small-Cap Value Stocks

Many investors overlook lesser-known smaller companies in favor of well-known behemoths, but there are some mighty values in small-capitalization (cap) stocks, according to Franklin Small Cap Value Fund Portfolio Manager Steve Ranieri. He outlines five things for investors to consider

Although small-cap stocks have performed well over the past decade, they have tended to underperform the large-cap stocks that have propelled the US equity bull market to record highs. In 2019, for example, many investors seemed to be concerned about how smaller companies would fare in a potential US economic slowdown, and they instead leaned toward larger, more well-known names.

As we move deeper into 2020, we see five reasons why investors might want to reconsider small-cap stocks. As value investors, we see stocks in this part of the market that fit our investment philosophy and which we think offer good potential.1

Reason #1: Excessive Pessimism

As the chart below shows, at the end of 2019, small-cap value stocks in the Russell 2000 Value Index were trading near the lowest levels in 10 years, compared to the large-cap value stocks in the Russell 1000 Value Index, as measured by price-to-earnings (P/E) ratios.2

We see a few reasons for this investor pessimism, including a belief that all small-cap stocks are more susceptible to a downturn in the US economy. Although that’s true for many stocks in the Russell 2000 Value Index, it’s not true for all of them, particularly select small-cap value stocks that have higher margins, lower leverage and decent earnings growth.3

As value investors, we believe these characteristics can lead to favorable long-term performance. Although investors have favored large-cap stocks over the past decade, small-cap value stocks have outperformed large-cap stocks over the 20 years ended December 31, 2019, as the chart below shows.4