The last decade has been very good for stock investors. The S&P 500(SNPINDEX: ^GSPC) has produced a total return of more than 300% since September 2015. The tech-heavy Nasdaq Composite index (NASDAQINDEX: ^IXIC) has climbed even higher, with a total return exceeding 400% in that time.
But not all stocks have participated equally in that rally. The biggest companies have grown bigger while smaller stocks get left behind. That’s seen not only in the record-high concentration of the S&P 500, but in the lagging performance of small- and mid-cap stocks. Small-cap stock indexes like the Russell 2000 and S&P 600 are up just 142% and 155%, respectively, in the same period.
But that may have created a once-in-a-generation opportunity for investors. Small-cap stocks historically outperform large-cap stocks, but the performance is tremendously cyclical. Those cycles can last anywhere from five years to 16 years historically. Indications are we may be reaching the end of an underperformance cycle, and small-cap stocks could outperform over the coming years. And if you add one simple filter to your stock selection, you can boost your returns even more.
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Over the last decade, the Russell 2000 index has underperformed the S&P 500 by an average annual return of 5.8%. That’s one of the worst annualized 10-year return differences for small-cap stocks on record.
While the Russell 2000 index only came into fruition in 1984, Distillate Capital analyzed returns of the middle 40% of stocks compared to the top 30% of stocks dating back to 1935. Never have the smaller stocks produced a 10-year annualized return differential below -6%. The analysts note, “In prior instances when relative returns reached similarly weak levels, reversals eventually occurred and gave way to multiyear stretches of significant outperformance.”
Indeed, the last time the differential was this bad was near the peak of the dot-com bubble. While large-cap stocks took the brunt of the blow as the bubble burst, small-cap stocks held up relatively well. In the 10 years from 2000 through 2009, the Russell 2000 produced a compound average annual return of 3.51% versus a negative 0.95% for the S&P 500.
But small-cap stocks don’t require two terrible bear markets to outperform after a period of significant underperformance. They also outperformed in the late 1950s and 1960s, when the S&P 500 was producing above-average returns for investors.
But banking on a trend reversal isn’t reason enough to invest in small-caps. There’s another historically significant reason why small-caps look particularly appealing right now, and why the trend could reverse soon.
A lot has been made of how expensive the large-cap index is these days. With a forward P/E of 22.2, the S&P 500 sports a historically high P/E ratio. But small-cap stocks, profitable small-cap stocks in particular, currently offer excellent value. The S&P 600, which requires companies to produce consistent profits on a generally accepted accounting principles (GAAP) basis, has a P/E ratio of just 15.7 times forward earnings expectations.
That puts the ratio of the S&P 600 to the S&P 500 valuations at 0.7. The last time the differential was that big was none other than 1999, the last trough in the overperformance/underperformance cycle for small and mid-cap stocks compared to large-cap stocks.
It’s worth pointing out that the Russell 2000 doesn’t sport nearly as attractive a valuation. In fact, the broader index’s valuation premium has increased substantially over the S&P 600 since 2020 after a gradual climb since 2013. That speaks to the importance of selecting quality small-cap stocks.
The S&P 600 uses a simple filter of GAAP profitability, which has led it to outperform the Russell 2000 by a considerable margin over the last 30 years. The researchers at Distillate Capital find that positive free cash flow is a strong enough filter for selecting quality small- and mid-cap stocks. Indeed, members of the Russell 2000 with positive free cash flow outperform the index in both bull and bear markets.
As such, you can take greater advantage of the current market environment by investing in small-cap stocks with consistent profits or positive free cash flow. One of the best options for finding quality small-cap stocks is the Avantis U.S. Small Cap Value ETF(NYSEMKT: AVUV). The fund manager uses selection criteria to filter out members of the Russell 2000, with its primary indicator of value being a company’s cash flow to book value ratio. For financial stocks, it uses adjusted net income to book value because of the structure and accounting of those companies. That ensures the fund is full of quality stocks only.
Investors will have to pay a slightly higher expense ratio for the ETF (0.25%), but it can be worth it since quality small-caps exhibit much better performance. Those who want to stick with a strict index fund may be able to find ETFs tracking the S&P 600 with a lower expense ratio. Be aware, however, that small-cap funds typically have higher tracking errors due to lower liquidity for smaller stocks. Either way you go, there’s a great opportunity for investors right now in small-cap stocks.
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Adam Levy has positions in American Century ETF Trust-Avantis U.s. Small Cap Value ETF. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.
