Small-Cap Value Stock Investing

Small-cap value stocks have been one of the top-performing style and size categories in U.S. stocks over the long-term.

Finding the Value Premium in Small Cap Stocks

Small cap stock investing involves buying stocks of companies with market capitalizations of between $300 million and $2 billion. Within the small cap universe, some of the best returns over time have come from small cap stocks trading at low valuations. This excess return is called the “Small Cap Value” premium.

The table below shows the return of small cap value stocks compared to the overall market since 1972. A three percent return above the market in any one year may not move the needle too much, but when compounded over nearly 50 years, it makes a massive difference, as you can see in the table below. Ten thousand dollars invested in small cap value stocks in 1972 would be worth over $6.9 million today vs. $1.7 million if invested in the broader U.S. stock market.

The excess return generated from small cap value stocks was first formally identified in the early 1990s by two academics, Eugene Fama and Kenneth French. The researchers set out to ask a simple question: “What are the drivers of long-term stock returns?”

Using financial statement and pricing data in the U.S. market back to the mid-1920s, they empirically showed that in addition to market risk, both value (cheap) and size (small) had influence on what stocks performed best in the markets. Since the research was initially published, both the small cap and value premiums have been shrinking, but many still think there is ample opportunity in the small cap value segment of the market.

The Risk/Return Tradeoff of Small Cap Value

The long-term returns in small cap value stocks present a compelling case for investing in this area of the market, but some of the key questions for investors are “why does this premium exist?” and “what is the risk and return trade-off if one is investing in small-cap value stocks?”

Small-cap stocks, due to their size and maturity in some cases, tend to be riskier than mid- and large-cap stocks. The risk in small caps shows up in two ways. First, small caps tend to have more price fluctuations and share price volatility vs. mid-to-large caps. Second, small caps in general have more variability in their underlying businesses and are affected more by economic contractions, recessions, changes in interest rates and other macro related factors that can have a larger, more meaningful impact on smaller firms with less resources.

There is also less efficiency in the small cap space; many small cap companies have little Wall Street analyst coverage and investor interest. Upward and downward earnings surprises can be harder to anticipate in a small cap stock.

When you layer in “value” with small caps, many of these risks get accentuated since value stocks are typically trading at a discount due to a perceived problem or underlying risk with their business. And when economic uncertainty increases and fear levels rise, there is potential for larger declines.

Part of the reason why small cap value investing works is because small-cap stocks are inherently riskier and investors should be compensated for taking that risk. But investor behavior or under-and-over reaction also plays an important role.

Small-Cap Value Realities and Opportunities

There are other important considerations in small cap value stock investing that contribute to the long-term return profile of this group.

The first is that small cap value stocks don’t always outperform the market and can actually go through long periods of relative underperformance. The decade-plus period following the Great Financial Crisis (GFC) in 2008 and 2009 is one example. Smaller cap value stocks were laggards in this period relative to major market indices like the S&P 500, which is market cap weighted and more influenced by larger stocks.

The excess returns in small cap value stocks tend to come in concentrated periods, and a large portion of the returns take place very early on in bull markets. In the early 2000s, small cap value stocks dramatically outperformed as investors shunned highly overvalued companies during the downturn and recession that followed the dot com boom. From the market bottoms in 2009 and Spring of 2020, small cap value stocks generated market outperformance in the early stages of both bull market periods. This would make sense since small cap value stocks are often hit the hardest during a bear market. And once investors sense an end to the decline, it’s those stocks that are hit the hardest that recover the most once investors gain confidence the companies can survive and recover.

Small-cap value stock investing comes with risk and rewards that are important for investors to understand, and even though the overall returns of small cap value stocks can be lumpy, there are always opportunities in the group. On the next card, you’ll see how small cap value stocks can be uncovered using a series of value factors.

Finding the Top Small Cap Value Stocks In Today’s Market

To uncover where the opportunities are in small-cap value stocks, investors can sort and rank on one or many valuation multiples using only the small cap stock universe as a way to generate new investment ideas. By clicking the link below, you’ll be brought to a page that lists the small cap stocks that get the highest composite score (i.e., combined score) using the following valuation metrics:

• Price/Earnings (P/E): This is a ratio of price per share relative to earnings per share. Stocks with low P/E ratios may be considered value stocks and as the profits for these companies improve, albeit slightly, the price of the stock should follow.

_{P/E = stock price per share / earnings per share}

• Price/Sales (P/S): This ratio looks at price per share relative to sales per share. Sales is less susceptible to adjustments and account gimmicky as compared to earnings. A low P/S ratio indicates an attractive value when compared peers.

_{P/S = stock price per share / sales per share}

• Price/Book (P/B): This ratio looks at price per share relative to book value per share. Investors using the P/B ratio are looking to buy stocks that look cheap based on their value of a company’s assets on its balance sheet.

_{P/B = stock price per share / book value per share}

• Price/Cash Flow (P/CF): This ratio looks at price per share relative to cash flow per share. Some investors prefer using cash flow since it is more difficult to manipulate than earnings.

_{P/CF = stock price per share / cash flow per share}

• Enterprise Value/Earnings Before Interest Taxes Depreciation and Amortization (EBITDA): This ratio looks at a firm’s enterprise value, which is its market capitalization plus debt minus cash on hand relative to its EBITDA. This measure attempts to look at a business in the way an acquiring company would if purchasing the entire business in a private transaction.

See the Top Scoring Small Cap Value Stocks in Today’s Market

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