Odds are good that small-cap stocks will rise this year.
But are those odds higher than they would otherwise be because this sector of the market did so poorly in 2022? That is the question recently posed by some on Wall Street, including Francis Gannon, co-chief investment officer at Royce Investment Partners. This firm is well known for its longstanding focus on the small-cap sector, and it offers a family of small-cap mutual funds. In his fourth-quarter recap provided to clients, Gannon argued that “most down years for small-caps have been followed by positive performance” the subsequent year.
Such a rebound would be welcome indeed. In contrast to a 7.0% total-return loss in 2022 for the blue-chip-dominated
Dow Jones Industrial Average,
Russell 2000 index
—a benchmark for the small- and mid-cap sectors—lost 20.5%. The
Russell Microcap index,
containing stocks with even smaller market caps, lost even more, 21.9%.
Nevertheless, it’s not clear that a loss for small-caps in one year increases the odds of the asset class rising in the subsequent year. To determine the probabilities, I analyzed U.S. small-caps’ annual returns back to 1866. I constructed this database using returns extending back to 1927 from Dartmouth professor Ken French and, for the six decades before then, from Robeco in the Netherlands.
What I found is summarized in the accompanying chart. Over the entire period since 1866, as you can see, the small-cap sector rose in 64.1% of the years. Following years in which the sector declined, small-caps rose 69.6% of the time. This increase from 64.1% to 69.6% isn’t statistically significant at the 95% confidence level that statisticians often use when assessing whether a pattern is genuine. I reached similar results when focusing on the period since 1927 as well as since World War II. Gannon didn’t respond to an email requesting his comments.
These results aren’t as discouraging as they might otherwise seem, however. Even though the odds of small-caps rising this year aren’t higher because 2022 was a losing year, they aren’t lower either. That’s important information because many momentum followers might otherwise worry that a down year for small-caps increases the likelihood of another down year.
The bottom line: There’s a two out of three chance that small-caps will rise in 2023. Those odds aren’t bad, by any means; they’re just not three out of four or four out of five.
To increase your chances of making money with small-caps this year, I turn to a study conducted several years ago by researchers at AQR Capital Management. Entitled “Size Matters, if You Control Your Junk,” the study was conducted by Cliff Asness, Andrea Frazzini, Ronen Israel, Tobias Moskowitz, and Lasse Pedersen.
The researchers found that the average small-cap stock in recent decades hasn’t performed as well as it would have otherwise because of the growing proportion of small-cap companies with low financial quality—junk, in other words. To fully capture the superior potential of small-cap stocks, therefore, it’s crucial to avoid small-cap junk stocks and focus on those of higher quality.
To determine a stock’s quality, the AQR researchers focused on those that score highly on several dimensions: profitability, profit growth, beta, stability of earnings, and dividend payout ratios—and which also have a conservative investment policy.
|Company / Ticker||Market Cap (mil)||Price /Book Ratio||Beta||Dividend Payout Ratio|
|Park Aerospace / PKE||$281||2.05||0.59||97%|
|Franklin Street Properties / FSP||315||0.79||0.81||41|
|Tredegar / TG||399||2.15||0.86||28|
|Resources Connection / RGP||588||1.62||0.77||28|
|Safety Insurance Group / SAFT||1,260||1.36||0.30||41|
|Getty Realty / GTY||1,640||2.01||0.88||115|
|Brady Corp. / BRC||2,556||2.62||0.75||31|
|LXP Industrial Trust / LXP||3,088||1.93||0.80||33|
|Greif / GEF||4,038||2.19||0.99||30|
|Kilroy Realty / KRC||4,769||1.42||0.84||38|
|OGE Energy / OGE||7,916||1.89||0.67||44|
Note: Beta measures a stock’s sensitivity to price movements in the overall market.
Sources: FactSet; Hulbert Ratings
The table above gives you an idea of the kind of small-cap stocks that satisfy these criteria. It contains the stocks within the S&P 1500 index that, according to FactSet, are above average in terms of returns on assets, five-year growth rates of return on assets, and dividend payout ratios, and which are below average in terms of price/book ratios and five-year betas. (Beta measures a stock’s sensitivity to price movements in the overall market.) The table further is limited to those stocks whose market caps are no larger than the largest in the Russell 2000 index. The stocks are listed in ascending order of their market caps.
Mark Hulbert is a regular contributor to Barron’s. His Hulbert Ratings tracks investment newsletters that pay a flat fee to be audited. He can be reached at email@example.com.
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