Bank of America says historically cheap small-cap stocks could outperform their larger peers over the next decade — and shares 3 sectors with the most compelling value opportunity

  • Small-cap stocks’ earnings growth is expected to outshine that of large and mid-cap peers.
  • BofA’s Jill Carey Hall detailed the value proposition of small caps in a recent note to clients.
  • The analyst also laid out three sectors where smaller stocks will outperform by the most.
  • See more stories on Insider’s business page.

Large-cap stocks have largely outperformed their small-cap peers over the last decade.

But in 2020 small caps managed to retrace some of those gains, with the Russell 2000, the leading small-cap index, returning 20% compared to the S&P 500‘s 16.3%.

While large caps have been able to regain their place as market leaders in 2021, Jill Carey Hall, Bank of America’s head of small and mid-cap strategy, wrote in a recent note to clients that small caps are set for an era of outperformance.

Earnings growth for small-cap stocks is outpacing large caps in a major way, and Carey Hall now expects nearly 100% earnings growth for small caps in 2021 compared to roughly 35% for large caps. 2022 growth is also expected to be in the mid-teens for small-cap stocks vs. the low-teens for large caps.

Carey Hall also described the rising price-to-earnings (PE) multiples of large caps in comparison with small caps. The Russell 2000 recently fell to a forward PE ratio of just 17.7x, according to the analyst, while similar large and mid-cap indices have seen their price-to-earnings ratios rise of late.

On top of that, inflows into small-cap funds still pale in comparison to cumulative outflows from small-cap stocks since late 2013, when smaller stocks’ secular underperformance cycle began. Active funds remain “underallocated” to smaller stocks as well, Carey Hall said, leaving plenty of runway for growth.

However, it’s important to note that small-caps stocks aren’t cheap on a historical basis — they’re only cheap in comparison to their large-cap peers. According to Carey Hall, small caps trade above their historical norms for most common valuation metrics, with the exception of Enterprise Value/Free Cash Flow.

In spite of this, small caps still present significant relative value, and while that value may not be a big draw to many growth-focused investors these days, according to Carey Hall it should be. In the chart below, the analyst illustrates how relative valuations create better returns, especially over longer time horizons.

The chart compares the correlation of relative forward price-to-earnings ratios to subsequent returns over various time horizons and clearly reveals the profitability that can come from finding stocks that trade at cheap valuations in relation to their peers.

BofA Valuations Chart

Bank of America

It’s evident being overweight small-cap stocks makes sense due to their earnings growth, relative value, and potential for major inflows, but which sectors present the most value?

Carey Hall and her team described three small-cap sectors that should have the most upside potential based on the quantitative metrics in her recent note to clients.

Those metrics include the number of positive analyst earnings estimate revisions each sector has received, which Carey Hall calls “one of the most alpha-generative small-cap factors.” The analysts also take into account the relative valuation of a sector compared to its historical averages, recent price momentum, and the net proportion of upgrades to downgrades in a sector by BofA research analysts, which has been found to be positively correlated with subsequent returns.

Using these metrics, Carey Hall found that cyclicals continue to dominate the quantitative rankings list, while defensive sectors like real estate, healthcare, and consumer staples rank at the bottom.

The top three sectors by quantitative rank include 1) Consumer Discretionary, 2) Energy, and 3) Financials.

BofA Small Cap sector ranks

Bank of America

While adding an ETF that mirrors the Russell 2000 index, like BlackRock’s iShares Russell 2000 ETF, might be alluring to those looking to gain exposure to small-cap stocks, taking a look at the sector weighting of the small-cap index should give savvy investors pause.

According to Siblis Research data, as of the end of 2020 only around 20% of the Russell 2000 index was made up of companies in the consumer discretionary, financials, or energy sectors, with financials (the lowest-ranked of the three) making up more than 75% that figure.

Investors might instead look to sector-specific small-cap ETFs like Invesco’s S&P Small-Cap Energy ETF, S&P Small-Cap Financials ETF, or S&P Small-Cap Consumer Discretionary ETF for a better proxy of Bank of America’s recommendations.

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