Small-cap stocks are in for a monster decade ahead, according to Research Affiliates Chief Investment Officer Que Nguyen.
Why? The two charts below paint the picture pretty clearly: both on a cap-weighted and equal-weight basis, the valuations of small-cap stocks relative to large- and mid-caps are incredibly low by historical standards. The current valuation gap rivals those seen during the dot-com bubble and the Great Recession.
Research Affiliates
“The potential for mean reversion to narrow this valuation gap creates an opportunity for small caps to outperform the narrowly focused large-cap indices over the next decade,” Nguyen wrote in a recent client note.
She added: “At the end of 2024, the valuation discount of U.S. small caps relative to a portfolio of U.S. large- and mid-cap stocks stood at -40%. This is a deep discount relative to the historical median level of -5%, standing in the bottom 4th percentile since 1990.”
In simpler terms, small-cap stocks — generally considered as those with market caps between $250 million and $2 billion — are rarely ever this cheap compared to their larger counterparts. And as the charts above show, they always bounce back strongly.
Nguyen sees small-cap indexes, on average, beating large-cap returns by about 4% annually over the coming decade.
When screened for momentum, quality, and value, the small-cap trade should do even better, she said. Since 1990, the cheapest quintile of small-cap stocks has returned 12.4% per year. Filtered for quality and momentum, they’ve returned 13.9% annually.
Small-cap stocks have been unloved in recent decades as mega-caps have outperformed. But as the US retreats from the rest of the world and the US exceptionalism trade fades, Nguyen said small-caps could be in a better position to drive innovation.
“As these very, very large behemoths become less dominant or find the system less welcoming to their dominance, it’s going to open up a lot of opportunities for smaller players,” she told BI in an interview on Friday.
“We can’t continue to have an innovative economy if small players can’t succeed,” she said.
Still, small caps tend to be more volatile and sensitive to downturns in the domestic economy, making careful screening essential.
Investors can gain broad exposure to the small-cap trade through funds like the Schwab Fundamental US Small Company ETF (FNDA), the iShares S&P Small-Cap 600 Value ETF (IJS), and the Royce Quant Small-Cap Quality Value ETF (SQLV).
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