Deep Dive: A bargain you can’t ignore: Small-cap stocks are trading at their second-biggest discount in 20 years

William Watts reported on what appears to be a breakout for small-cap stocks after eight months of relatively flat performance. That is based on the movement of the Russell 2000 Index
RUT,
+0.55%.

In this article, we are focusing on the S&P Small Cap 600 Index, which is far more selective than the Russell 2000 because because most of its companies are profitable. Standard & Poor’s criteria for initial inclusion in the index includes positive earnings for the most recent quarter and for the sum of the most recent four quarters.

Aside from the early coronavirus pandemic doldrums of March 2020, the S&P 600 Small Cap Index hasn’t traded this low, relative to the S&P 500, in 20 years.

Here’s a breakdown of the relationship between current and average forward P/E ratios for the two indexes, using weighted data compiled by FactSet:

The small-cap group typically trades much closer to the valuation of the large-caps than it does today.

Now take a look at a 20-year comparison of total returns for the two indexes:

In an extended bull market, driven in part by historically low interest rates, it is understandable that the best-known stocks (the large-caps) have had the most benefit. But all of the above argue for adding exposure to small-caps for the long term, as part of a diversified portfolio, especially if you have a lot of money in an S&P 500 index fund or exchange traded fund.

For a shorter-term case, see this comparison of aggregate consensus 2022 estimates among analysts polled by FactSet for the two indexes:

Good numbers across the board — but the estimates are higher for the small-cap group.

For both groups, the free-cash-flow estimates are comforting. Free cash flow is a company’s remaining cash flow after planned capital expenditures. It is money that can be used for expansion, dividend increases, stock buybacks or other corporate purposes.

How to get exposure to small-caps

If you are fortunate enough to have access to an employer-sponsored retirement account, the most important piece of advice anyone can give you is to contribute at least as much as your employer’s maximum contribution. If you do that, you have an immediate 100% return on your contributions.

Then you should look at the fees charged by the mutual funds available within the 401(k) or similar plan. Index funds, which typically have lower expenses than actively managed funds, may be available, and these may include a small-cap fund. Your plan may also allow you to put money into a brokerage account, within which you can select exchange traded index funds that also have low expenses.

Here are a few ETFs that track the S&P Small Cap 600 Index:

• iShares Core S&P Small Cap ETF
  IJR,
  +0.11%
• SPDR Portfolio S&P 600 Small Cap ETF
  SPSM,
  +0.19%
• Vanguard S&P Small Cap 600 ETF
  VIOO,
  +0.16%

Small-stock screen: Analysts’ favorites for 2022

Among the S&P Small Cap 600, there are 24 stocks with 100% “buy” or equivalent ratings that are each covered by at least five analysts polled by FactSet. Here they are, sorted by the 12-month upside potential implied by the consensus price targets:

Click on the tickers for more about each company. Click here for Tomi Kilgore’s detailed guide to the wealth of information for free on the MarketWatch quote page.

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