Small-cap watchers warn investors to moderate expectations

The rally might not last forever as interest rates rise

Mar 25, 2014 @ 10:46 am

By Trevor Hunnicutt

Small-cap stocks have been going gangbusters, but market analysts say it's time for those companies to start earning their keep.

“2014 is the year when markets need to validate the multiple expansion that we've been seeing,” said Stephen Wood, chief market strategist for Russell Investments. “The fundamentals this year need to justify those valuations.”

Speaking on a panel sponsored by Russell, creator of a popular benchmark for U.S. small-caps, market watchers cautioned that the stock category is facing rougher seas ahead.

The Russell 2000 Index gained 37% last year. As of Monday it was up about 1.25% so far this year, according to research firm Morningstar Inc.

As of March 20, exchanged-traded funds that focus on small-caps saw $5.73 billion in new flows this year, compared with withdrawals of $10.7 billion for funds investing in large companies, according to Bloomberg.

Bloomberg said a quarter of the companies in the index failed to earn a profit last year, but as a group, their shares are up 7.6% this year. Shares of more profitable companies did not gain as much.

Describing the market as an “alpha play,” Mr. Wood said: “Security selection is going to be more important” as the companies' valuations have swelled.

“Now it's more of a show-me state, where we're going to have to see earnings growth,” said Steven G. DeSanctis, head of small-cap strategy at Bank of America Merrill Lynch Global Research. “There's not a lot of bargains to be had in small-cap stocks … There's not a lot of value in the index.”

The longtime small-cap watcher sees a potentially toxic brew for the sector: With the Federal Reserve continuing to taper its bond purchases, markets could grow more volatile, creating an environment poor for more-risky assets, such as small-caps.

And when valuations are in the top quintile, small-caps have tended to underperform the large-cap-tracking S&P 500 by nearly 5% over the following year, according to Mr. DeSanctis.

He said housing-related investments, a major underlying component of the small-cap index (18.9% of small-cap profits are housing-related, compared with 10.2% for large-caps), typically suffer as interest rates move higher.

The larger-market-cap companies with higher expected earnings within the index are likely to perform best, he said. Industrial companies have overseas exposure and do better in a rising-rate environment, making that sector more attractive, Mr. DeSanctis said. U.S.-based small-caps have greater exposure to the U.S. (only 19% of their sales come from outside the country, versus 35.4% for large-caps).

Daniel Gamba, head of the iShares' Americas Institutional Business at BlackRock Inc., cautioned that most investors should avoid market timing, allocating a core exposure to small-caps for the long term. In general, investors trade too late for their tactical insights to be of much value, he said. BlackRock's iShares division sponsors an ETF based off the Russell 2000 benchmark, IWM, with nearly $30.4 billion in assets under management.

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