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Investors are becoming more optimistic that central bank tightening may slow down or reverse by the end of 2023 or early 2024 giving a boost to risk equities, including small caps.Michael M Santiago/GettyImages/Getty Images

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Even though small-cap stocks represent a mere 10 per cent of the equity universe, they generate an outsized emotional response with polarized groups of lovers, haters, enthusiasts and abstainers.

As such, they tend to be unloved and, therefore, undervalued for stretches of time although these same attributes also make them ripe for active stock pickers.

Perhaps one of the reasons why investors shy away from small caps is the evolutionary predisposition to perceive “safety in numbers,” represented by investing in large- or mega-cap stocks. It’s among these corporate giants where investors feel protected, nestled among millions of others.

Investors also tend to equate heft with safety and higher quality. There’s a reason many luxury car brands have heavy doors that close with a thud. That thud gives drivers confidence the car’s not a dud. The same goes for wine consumers, especially new wine drinkers, who connote bottle heaviness with quality.

Small public businesses with market caps of less than $1-billion seem to suffer from this bias and are eschewed in favour of their big-cap brethren. However, a closer look reveals that quality small-cap stocks can offer investors outsized returns and bring diversification to a portfolio.

They should not be dismissed, particularly at today’s attractive valuations. Here are five reasons to reconsider small-cap stocks.

1. Small caps outperform as the economy improves

Bear market recoveries are often associated with outperformance in small caps. During periods of economic stress, smaller companies are affected disproportionately. These businesses have lower capital structures and most, if not all, of their revenue is generated domestically, making it harder for them to invest during downturns.

However, as economic conditions improve, small-cap stocks tend to outperform large caps as dominance shifts between the two. That makes them an important tool for portfolio diversification.

Moderating inflation also provides a tailwind for small caps. Investors are becoming more optimistic that central bank tightening may slow down or reverse by the end of 2023 or early 2024 giving a boost to risk equities, including small caps.

2. Attractive valuations

Absolute valuations in small caps, as measured by the Russell 2000 Index, have not been this low since the global financial crisis and the post-dot-com bubble era.

Relative to large caps, small caps have been this inexpensive only 7 per cent of the time in almost 30 years, according to Bank of America Corp. data. If history is any guide, this could be a backdrop for a long period of outperformance similar to the period between 2009-2020.

3. Lower trading volumes open door for investors

Small caps have lower trading volumes, which can lead to big price dips. That means during periods of high volatility, investors with high conviction can create meaningful positions at attractive valuations.

One reason large brokerage houses concentrate their research on larger companies is they need to trade in huge volumes. Giving a buy recommendation on a small stock could result in institutions buying up every available outstanding share and then some, which will not happen. That leaves the field open to more nimble investors unrestricted by size minimums.

4. Easier for smaller companies to adapt to conditions

Elephants don’t gallop. Smaller companies are entrepreneurial and nimble making them better able to pivot to market conditions, especially during economic recoveries. Whereas a large company may take several years to execute on changes, a smaller company can do so rapidly.

Furthermore, the management teams in smaller companies are closer to their customers. That allows them to act decisively to incorporate changes to their strategic and growth plans. Going back to the Great Depression, small-cap stocks outperformed large-cap stocks during inflationary periods like the one we’re facing today.

5. Small caps are not a crowded trade

While large-cap stocks are followed closely by analysts and investors, small-cap stocks are often under the radar. It takes patience and a great deal of research to identify quality small-cap stocks.

Establishing a position in a small-cap stock requires the conviction that only comes with extensive research, something many investors will not or cannot do.

Investors must roll up their sleeves and do the work by reading publicly available regulatory documents and doing scuttlebutt research by talking to the company, its competitors, and suppliers.

David Barr, CFA, is chief executive officer and portfolio manager at PenderFund Capital Management Ltd. in Vancouver.

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