How to Invest $1,000: Buy Small-Cap Stocks
Among the cheapest investment options this fall are small-cap stocks — often defined as companies whose total market capitalization (share price times number of shares) ranges from $300 million to $2 billion.
The Russell 2000, an index that tracks the 2,000 smallest publicly traded companies, traded with a price-to-earnings ratio based on estimated earnings that was between 15 and 20 this summer, its lowest level in more than a decade. That discount is one of the main reasons Ed Clissold, chief US strategist at Ned Davis Research, turned bullish on small-caps this summer. “Small caps could be in the early stages of multi-year outperformance,” he says.
The story is certainly encouraging. The last time small-cap stocks were this low – ahead of the 2001 recession – the sector has clearly outperformed. For example, if you had bought a fund tracking the Russell 2000 Index as the recession began in March 2001, you would have had a cumulative total return of 42% through March 2005. The large-cap Russell 1000 index had only just begun to recoup losses, up just 6%.
There are many other reasons to pick up a flyer about small caps. Clissold believes they will benefit disproportionately from trends such as deglobalization and a stronger dollar as small caps tend to be more US-biased. And several academic researchers have found that small-cap stocks tend to outperform those of large companies over the very long term.
All of this could make savvy investors suspicious: if all of this is true, why are small caps so unloved now?
Four key reasons: Small caps are more volatile than large companies, and many investors can’t stomach their volatility. Second, it can be difficult for fund managers to buy or sell large shares without prices moving, as companies tend to have a comparatively small number of tradable shares. Their size also makes them more vulnerable to economic downturns, so they tend to fall faster in the early stages of recessions. After all, small-caps just couldn’t keep up with skyrocketing growth-oriented tech stocks like Amazon.com, Tesla, and Alphabet. As a result, broad small-cap indices have generally underperformed large-cap benchmarks since about 2008.
Given the risks, especially around a potential recession, it pays to be selective. A great way to delve into this sector is with T. Rowe Price’s Small Cap Value fund, one of the Kiplinger 25, our list of our favorite no-encumbrance mutual funds. This 34-year-old fund has a long track record of outperforming its benchmark, beating similar funds in eight of the last 10 years and so far this year, according to investment research firm Morningstar
Lead fund manager David Wagner says he’s looking for bargains that also have strong earnings prospects. The fund owns approximately 300 companies in the Russell 2000 and is currently low in risky, expensive technology companies and high in industrials, energy, resources and financials. “Higher interest rates are positive for banks because they can generate higher returns,” says Wagner. And deglobalization and international conflicts can create opportunities for domestic industrial and energy companies.
Wagner says that while the outlook for the next few months is bleak, he is confident in the medium term. “This is a great time to buy small caps… Trying to time it perfectly is foolish. If you wait until the recession is in the rearview mirror, it might be too late.”
In the latest Kiplinger’s Personal Finance Magazine, our editors offer advice on how to spend, save, and invest on $1,000. Get more smart tips:
- Add small caps to your portfolio
- Use fractional shares to buy small amounts of expensive shares
- Find an affordable way to learn new job skills
- Borrow money for a good cause