In one part of the stock market, the recession has already happened, and it was a doozy.
Small-cap stocks in Canada and the United States have been pummelled this year, which tends to occur whenever economic risks bubble up and hijack investor sentiment.
But so thorough has been the drubbing that the average small-cap stock is trading at a near-peak discount to its large-cap counterpart – a gap rivalling the worst moments of modern economic history.
Each of those previous episodes, however, ultimately set the stage for soaring returns in small-cap stocks, which tend to lead the way out of a bear market.
That was certainly the case two years ago.
The outbreak of the COVID-19 global health crisis produced the fastest and steepest downgrades to global growth ever seen, which landed especially hard in the small-cap segment.
Facing a global economic shutdown that threatened to morph into a depression, it was hardly a surprise that investors would turn against the economically sensitive small-cap space with extreme prejudice.
In less than a month starting in February, 2020, the U.S. Russell 2000 small-cap index dropped by 42 per cent, as investors scrambled to reduce their exposure to riskier assets. Over the same time, the S&P/TSX SmallCap Index lost 46 per cent.
But here’s where investors leery of the small-cap space should take note – the pendulum swings just as dramatically in other direction.
Starting in February, 2020, as the stock market started to sniff out an economic rebound from the pandemic, small-cap stocks began a steep ascent. Over the next year, U.S. and Canadian small-cap benchmarks gained 129 per cent and 125 per cent, respectively.
(Small-cap definitions vary, but generally they’re considered to be stocks with a market capitalization of less than $2-billion.)
“The hardest part of small-cap investing is capturing that upside,” said David Barr, chief executive of Vancouver-based PenderFund Capital Management. You need to either stay invested in the space through the bad times, which, it seems, relatively few everyday investors had the stomach for over the past year or so. Or you need to build up your small-cap exposure at times like this, when the space has been largely forgotten by the investing masses.
“Our U.S. and Canadian small cap strategies have already discounted a recession of the magnitude of the financial crisis,” Christopher Guthrie, president of Hillsdale Investment Management, wrote in an e-mail.
The price-to-equity ratio on the average U.S. small cap stock is currently more than 30 per cent lower than where the S&P 500 is trading.
Despite a rough year for stocks of all sizes, large-cap U.S. stocks are still not cheap, with valuations sitting above long-term averages.
“At the very least, investors who have become uncomfortable with S&P 500 valuations can still find bargains in the small cap space,” Lori Calvasina, head of U.S. equity strategy at RBC Capital Markets, wrote in a recent report.
The same goes for Canada. The S&P/TSX SmallCap Index typically trades at a P/E of about 14.5. Today it sits at 10 times forward earnings estimates, according to data provided by Hillsdale.
A caveat on valuations, however: They are a notoriously lousy timing tool. They won’t signal when a turning point is near, and the small cap sell-off could continue on for some time.
“A lot of times people will say, ‘this looks like a great entry point,’ then the market moves another 5 per cent against you and they think they made a mistake,” Mr. Barr said. But research generally shows that when small-cap stocks are this cheap, they tend to outperform large-cap indexes over the next several years.
Popular interest in small-caps tends to be highly fickle. Retail investor participation in the space plunged alongside small-cap indexes themselves, which have lost between 20 per cent and 25 per cent in the U.S. and Canada since November.
Prior to that, a new cohort of retail investors trading on discount brokerage platforms helped breathe new life into small cap stocks, particularly among tech startups, renewable energy and ESG names. A Bank of America report found retail traders generating about 30 per cent of trading in some small-cap names on peak trading days through the stock market boom in 2020.
Signs of renewed interest are starting to show up. “We’re starting to see capital coming back in on the retail side,” Mr. Barr said. “We’ve certainly seen increased activity on Reddit.”
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