Why you shouldn't overlook small caps in your portfolio

While the S&P 500 (^GSPC) has reached record highs, the Russell 2000 (^RUT) has lagged behind as small caps struggle to keep up with the broader market. SS&C ALPS Advisors chief ETF strategist Paul Baiocchi joins Market Domination to discuss why investors should be more bullish on small caps despite their underperformance.

"You have to go back to the end of the .com era to see any time when small caps, at least at a price level, have looked like this relative to large caps. Then you look at valuations and you look at the PE spread between large caps and small caps as defined by the Russell 2000 and S&P 500. And historically speaking, when you get that type of anomalous relative valuation, it does portend to potentially strong relative performance on a go-forward basis. But as always, any time there is a valuation story in the market, you have to think about what it means short-term and long-term. Valuation is not necessarily a signal for near-term outperformance, but there's reasons why small caps are relatively cheap compared to their large-cap counterparts," Baiocchi explains.

He believes there are strategies for investors to get into small caps without risking too much. He points to ALPS O'Shares US Small-Cap Quality Dividend ETF (OUSM) as an opportunity as it screens for companies with high profitability, low leverage, and strong dividends.

For more expert insight and the latest market action, click here to watch this full episode of Market Domination.

This post was written by Melanie Riehl

Video transcript

Small caps simply put, are struggling to keep up with the broader market.

While the S and P 500 has matched numerous record highs since the year began.

The Russell 2000 has gained less than a half of 1%.

We're looking at how to navigate small caps in your portfolio with the Yahoo Finance playbook joined now by a BA A, he's SSNC Alps Advisors, a chief ETF strategist.

It's great to have you here, Paul.

So walk us through exactly why maybe now investors should be rotating just a bit and be a bit more bullish on small caps given the underperformance that we've seen now for some time.

Well, I think you touched on it in your lead in where basically the S and P 500 continues to climb and make new all time highs.

And yet the Russell 2000 small and mid caps really haven't done anything to participate in that rally and you go back five or six years and you've basically had sideways action in small caps.

And if you look at the ratio between the Russell 2000 and the S and P 500 so just divide one by the other.

And we're at the lowest levels we've seen in more than 20 years.

You have to go back to the end of the.com era to see any time when small cap, at least at a price level have looked like this relative to large caps.

Then you look at valuations and you look at the pe spread between large caps and small caps as defined by the Russell 2000 sp 500.

And historically speaking, when you get that type of anomalous relative valuation, it does portend to potentially strong relative performance on a go forward basis.

But as always, anytime there is a valuation story in the market, you have to think about what it means short term and long term valuation is not necessarily a signal for near term out performance.

But there's reasons why small caps are relatively cheap compared to their large cap counterparts.

What about uh Paul earnings growth for the small caps just broadly?

What do you expect versus large caps?

Well, I think the earnings growth picture for small caps is significantly muted compared to large caps.

Although I will say that a lot of the large cap growth, at least in earnings in aggregate is dragged up by the significant growth we're getting from the top of the cap spectrum.

So growth expectations for the Russell 2000 in a s mid cap universe is much more subdued than for a large cap universe.

And as we talked but there are warts in this universe.

You do have a valuation story in place, but you have 9% of the Russell 2000 in regional banks.

That's a segment of the market that faces significant economic headwinds.

You have 40% of the Russell 2000 famously, that doesn't make money.

So forget about earnings growth.

Just think about profitability in and of itself and then you have 50% or so of that index, which has floating rate debt.

So when thinking about allocating to small and mid caps, I think of a lot of allocators and a lot of advisers are trying to balance what they see as an economic cycle that might be favorable to small caps.

They typically perform well when you get to the end of a fed rate hiking cycle, but also that valuation story.

So Paul, I guess my question to you is where are you seeing those opportunities given when you take a look at the Russell 2000, there's a heck of a lot of companies in there.

When you take a look at those balance sheets, they look very different in terms of profitable, uh those that are profitable and those are not.

So ho how are you, I guess determining those winners?

And then when we talk about catalyst, how much of this call is contingent upon the fed cutting in terms of what that catalyst is going to be.

When we talk about a bit of this shift in rotation.

Well, I think there's very simple ways to reconfigure a small and mid cap oriented strategy to avoid some of the worst outcomes.

So something that O US M the ETF Alps offers does is it screens for companies with high ro a so profitability, low leverage, so low net debt to EBITA companies that pay dividends have grown their dividends and have strong dividend coverage.

So you call that universe down to let's say 100 100 and 15 names that are defined by the quality characteristics that an active manager might look for when picking and choosing in that market.

And when you look at historically at the risk reward profile of a quality oriented small and midcap portfolio, it may not give you full leverage to a rip your face off rally in small and mid cap stocks.

But ideally what it does through its low volatility screens as well as those quality screens is avoid some of the worst companies in that universe and therefore some of the worst drawdowns in that universe.

But in terms of catalysts, one of the things that historically has been positive for small caps is when you get this type of wide valuation gap between small and large cap companies, which we currently see.

But also if the fed does indeed start to cut rates one time, two times or more into the back half of 2024 into 2025 that should ease some of the tension economically on some of those be for small cap companies because I mentioned 9% of the Russell 2000 is in regional banks.

Well, why have regional banks suffered so much over the course of the past year and a half?

Largely because of a mismatch between deposits, a mismatch between capital flight and importantly, a mismatch between what they've lent money at and what they're borrowing money at in terms of rates.

All right, Paul Bay, we have to leave it there.

Thanks so much for taking the time to join us today.

Thanks for having me.