Is it too late to invest in small caps?

by Jason Whiting, Invesco Canada

Over 10 years into an economic expansion, and with recession concerns moving to the forefront, many investors are asking whether it is too late to invest in small-cap stocks. Conventional wisdom says that small caps are hit harder in a recession than large caps, so if a recession is imminent, then one should not own small-cap stocks. But I believe this is the wrong question to ask. For investors who are concerned about small caps, I would note three things: Trying to time the market is generally a fool’s errand, small caps have delivered historical long-term outperformance, and small-cap valuations look attractive, in my view — especially in certain industries.

1. The problem with market timing

People have repeatedly tried, and failed, to time the market. Research from Dalbar shows that equity mutual fund investors tend to take money off the table at the wrong time. Exiting a declining market out of fear often results in investors missing out on an ensuing recovery.

2. Strong long-term performance

In my view, a better strategy is to pick an asset mix that is right for you and stick with it for the long run. Should that include small caps? Consider this: From February 1979 to February 2019, the S&P 500 Index rose 89-fold. Not bad. Yet over the same period, the Russell 2000 Index (generally considered representative of the U.S. small-cap space) rose nearly 132-fold.¹

3. Attractive valuations

Small caps might be even more attractive than usual given “everyone” is worried about how small caps will do in a potential recession. If everyone is negative on small caps, then that belief is priced into the stocks and there is no advantage to having that opinion.

Currently the Russell 2000 Index trades at a price/earnings valuation discount to the S&P 500 (16.4x vs. 19.0x).² This is near the biggest discount in the last five years and a major difference from the usual premium at which the Russell 2000 trades.² Small caps have outperformed large caps over time AND small caps are currently cheap compared to large caps, a powerful combination.

Finding opportunities in small caps

The Invesco Canada Equity team, which manages small-cap funds in the US and Canada, seeks to go against consensus opinion in our funds. A good example of this is Delphi Technologies. (In the US, Delphi represented 2.49% of Invesco Select Companies Fund and 2.55% of Invesco Select Opportunities Fund as of June 30, 2019.) (In Canada, Delphi represented 2.49% of Invesco U.S. Small Companies Fund, 2.57% of Invesco Global Small Companies Fund and 4.23% of Invesco Canadian Small Companies Fund as of June 30, 2019.)

Delphi is a supplier of engine technologies to the global automotive industry. Currently, the market “knows” that the auto industry is in a downturn and that tariffs are hurting the entire auto business. Additionally, some investors won’t own any internal combustion engine company due to the future risk of electric vehicles. Due to this extreme negativity Delphi’s stock was down 78% in August from its high reached in January of 2018.³

Are any of these negative views on Delphi or its industry unique? Delphi’s stock has been trading at a price-to-earnings (P/E) multiple of approximately 5x 2019 consensus,³ implying virtually all investors have the same negative opinion on Delphi. In the long-run, our team believes that the auto cycle will improve, and the industry will adapt to the cost pressures of tariffs. Delphi specifically has a broad portfolio of technologies applicable to the electric engine and has won billions of dollars of awards in this area. We believe Delphi’s potential earnings power is above its current level. We believe investors will again turn positive on the automotive space, and we see little chance of Delphi trading at 5x earnings then.

This post was first published at the official blog of Invesco Canada.