Small companies tend to underperform in recessions and bear markets because they simply don't have the same resources as large companies and aren't industry leaders that can more easily survive unexpected emergencies.
Investing in small-cap stocks can be a good idea, especially when the economy is in recovery mode. In such periods, small-cap stocks frequently surpass larger ones owing to their greater potential for growth. However, they are also more volatile and can be riskier.
Small-cap funds are riskier than large-cap funds and may not be suitable for everyone. Small-cap companies are more sensitive to market changes and can experience sudden and wide price fluctuations. Small-cap companies are less popular and smaller in size, making their stock less liquid.
However, the highly overstretched valuation of large-cap stocks, together with a few positive developments may shift market participants' preference from large to small-cap stocks. At this stage, we recommend small cap stocks with a favorable Zacks Rank that have strong growth potential for 2025.
Most investors think smaller companies underperform in a recession. In most cases, they are correct. However, what's less well-known is that small caps usually exit recessions quicker than assumed – outperforming large caps. This rebound can begin as early as three months into an economic downturn.
The small cap segment can be extremely volatile in the short term, but they have the potential to offer very high returns over a long period. Small cap schemes are recommended only to aggressive investors with a high-risk appetite and long investment horizon, say, around seven to 10 years.
To find an appropriate investment mix for your time horizon, find your age and the corresponding portfolio allocation. A typical mixture could include 60% large-cap (established companies), 20% mid-cap/small-cap (small to medium-sized compa- nies), and 20% international (companies outside the U.S.) stocks.
As of October 19, 2024, the small cap index was overvalued at a Price-to-Earnings (P/E) of 33.39, while the 3 year long term average stands at 24.49. But experts think there are certain sectors within the small cap that are fairly valued.
Given the changing macroeconomic backdrop, we outline why we see potential value for investors in small caps in 2024. The consensus is that interest rates look to have peaked, with markets now pricing in cuts across many major economies in 2024, something which could prove beneficial to small caps.
Small-cap is not a bad thing, it is just that you should have the time-frame. If you're investing for any 10 year, small-cap will beat all other kinds of funds hands down, but if you are coming with a very short-term expectation, you will be very surprised in a very negative way.
Small-cap valuations – Attractive
We expect earnings to drive the next leg higher for small-cap share prices. Analysts are looking for robust earnings growth: 15% this year, and by over 30% in 2025 and 2026. That is ahead of the long run rate of 13% growth (see Exhibit 3).
Small caps can diversify portfolios and bring higher growth potential — albeit with higher risks. However, the value of small-cap stocks grew more than 10% in the first 10 months of the year, buoyed in part by the Federal Reserve interest rate cut in September.
Since the start of 2023, the S&P 600 small-cap ETF has advanced around 25% as of the time of this writing. That's not bad for a roughly two-year period. But the S&P 500 index (^GSPC -1.54%) is up about 50%, or roughly twice as much. That's a massive outperformance on the part of the large-cap S&P 500 index.
Small-caps, on average, outperform large-caps by about a percentage point for the six months after a 50 basis point cut, she writes, and the majority of those periods see small-caps outperform by any degree. They average about three percentage points of superior returns over the 12 months following such a rate cut.
The bottom line is that companies that comprise small-cap indices collectively present higher risks than the companies that make up large-cap indices. But this doesn't mean that small-cap companies can't be a valuable part of an investment portfolio.
Small-cap mutual funds are ideal for you if you have an investment horizon of five years and above, as small-cap stocks are volatile in the short term, and small-cap funds perform better in the long term.
While small caps have historically outperformed their large-cap brethren in periods when annual inflation has exceeded 1%, the higher interest rates that come when central banks try to reduce high inflation can be challenging for small companies.
Capital-intensive industries such as technology and utilities often perform well after rate cuts. Sub-industries within the financial sector, such as asset management and insurance, are likely to outperform.
Investing in small caps during recessions has generated superior investment returns, according to our back-testing of the data to the late 1980s (see Table 1, below).
Historically, small caps tend to excel in the final two months of the year, with November's impressive gains often rolling into December as part of the so-called “Santa Rally.”
Nifty Smallcap 100 index has fallen 4% to its lowest level since mid-June amid concerns about Q3FY25 performance. Disappointing earnings results have led to increased selling pressure, with many stocks down significantly from their 1-year highs and foreign investors pulling out funds.