This article first appeared in Forbes.com.
Co-founder/CEO of PAX Financial Group, LLC.
Do you remember the mobile game Angry Birds? Pull back the slingshot, and the bird demolishes all construction to advance to the next level. Yes, it was fun. But what if you had a slingshot for your investment portfolio after a recession? You know, the type of investment that typically accelerates faster than others and gives the lift your portfolio needs after drowning in the latest economic turmoil.
That type of investment may be right under your nose: small-cap stocks.
The Why And How Of Small Caps
According to Prudential, over nine recessions, small-cap stocks averaged a 34% rate of return one year after the recession ended. Digging into the data a little more, Prudential’s research only evaluates the data up to 2001. So, what does the data tell us in this post-dot-com world about small caps coming out of recessions? Well, according to TradeSmith, the case for investing in small caps out of a recession after 2001 is even more compelling. For example, small caps rose 111% one year after hitting their lows in 2009 during the Great Recession. Even after 2020’s brief Covid recession, small caps roared back 117% one year later.
The reason small caps tend to bounce back from recessions is they get bullied when the economy is struggling. In a recession, money and lending tighten making it more difficult for small companies to get the cash needed to weather the storm. This cash flow threat drives down the prices of the stocks, and they continue to stay low until the clouds clear. Then, as signs of recovery appear, the market takes notice of the undervalued small-cap stocks, and it goes on a shopping spree, driving the price of the small-cap stocks up.
Here are three ways to invest in small companies:
1. Exchange-traded funds. ETFs are the lowest-cost way to get small-cap stock company exposure. Not only do you get low cost, but you also can sell intraday should the small-cap stocks get “angry.” However, be careful of too much intraday trading as the short-term capital gains could erode much of the returns.
2. Mutual funds. Through a mutual fund, you will pay more for analysts to nerd out on research reports. Still, according to Morningstar data, using “rolling three-year periods from 2005 to 2019, the average small-cap manager outperformed the Russell 2000 (the main small-cap benchmark) 86.7% of the time.” If you get a well-managed one, you get your money’s worth.
3. Individual stocks. Sometimes buying individual stocks is a good idea considering that many high-performing small-cap fund managers get too large and can’t own small-cap companies anymore without swallowing the company as a whole. If you don’t want to do the research yourself, for higher minimums and fees, separately managed accounts can buy those individual stocks for you.
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Allocation Considerations
One question is how to buy small-cap stocks, but “how much” is another.
Small caps have inherently more risk than larger companies due to limited access to cash. When markets tighten, banks generally lend to the big boys over the small ones. Small caps also have a less diversified product offering, usually focused on a niche, geography or emerging technology. With those risks in context, here are general guidelines about how much small cap to include in a portfolio given two different holding periods:
o The accumulator: Suppose you are working, saving and accumulating money (i.e., not retired). In this case, you’d likely want to place a limit on the amount of your portfolio in small-cap stocks. Any more than a reasonable amount creates way too much risk. Small caps have more volatility, so if you have a 50% drop in your portfolio value, it would take 100% to get back to even. You might be able to handle that on a quarter of your money, but not all of it.
o The distributor: If you are retired, your strategy is likely different. I suggest you develop your financial retirement plan and determine whether cushion money exists. This would be a bucket of money above and beyond your retirement needs based on life expectancy. Maybe this is money you have thought of leaving as an inheritance. If your time horizon on this inheritance bucket of money is longer (10-plus years), you may be able to stomach the ups and downs that come with this type of asset class.
Small-cap stocks are full of exciting stories of American innovation. Owning them can be a significant benefit of stock market investing. But remember that sometimes the slingshot makes the Angry Bird go where you want it, and sometimes it doesn’t work out how you planned. That risk profile is welcomed by long-term investors, especially after a recession.
The information provided here is not investment, tax or financial advice. You should consult with a licensed professional for advice concerning your specific situation.
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