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Traders work on the floor at the New York Stock Exchange (NYSE) on May 26, 2020.Brendan McDermid/Reuters

Some investors believe the stars are aligning for small-cap stocks, as the category stands to benefit from cheap valuations, robust economic growth and a relatively benign impact from looming tax policy changes.

About US$2.4-billion has flowed into U.S. small-cap equity funds so far this month, already the biggest monthly inflow since March, according to data provider EPFR. That’s helped fuel a 6-per-cent gain in the S&P 600 small-cap index since late October, nearly doubling the large-cap S&P 500′s performance in that period. The Russell 2000, a broader small-cap index, is up about 5 per cent.

Small caps, which have a median market capitalization of US$1.2-billion in the Russell 2000, rallied in the early months of 2021 as investors bet that smaller firms would benefit more from a broad U.S. economic reopening. They floundered in subsequent months, when technology stocks took the market’s reins amid worries over whether the Delta variant of the coronavirus would stifle the economic rebound. The Russell 2000 is up 19 per cent this year against a 25-per-cent rise for the S&P 500.

With a blistering S&P 500 rally stretching valuations on large-cap stocks and above-trend U.S. growth expected next year, some investors now believe small caps are a bargain.

The forward price-to-earnings ratio of the Russell 2000 compared to the large-cap Russell 1000 recently stood at 24 per cent below its long-term average, while small caps also trade at historical discounts on other measures such as price-to-book and price-to-sales, according to BofA Global Research.

“Smaller-cap stocks on a relative basis just look much more attractive,” said Ryan Jacob, chief investment officer of Jacob Asset Management.

His firm’s growth stock funds “probably have our highest weightings ever” in small-cap shares compared with large, Mr. Jacob said.

Royal Bank of Canada strategists said the U.S. economy is expected to expand 4 per cent next year, compared with its long-term average of 2.5 per cent, and believe small caps are a “pure play” on domestic growth. Analysts at BofA Global Research said the disparity in valuations between larger companies and smaller ones suggests high single-digit price returns annually for the Russell 2000 over the next decade compared with slightly negative annual returns for the S&P 500.

Chuck Carlson, chief executive officer at Horizon Investment Services in Hammond, Ind., said his firm has added more small-cap exposure in the past four months, including shares of shipping company Matson Inc. and semi-conductor firm Onto Innovation Inc.

“After trading pretty much sideways for seven months, you had a pretty nice breakout,” Mr. Carlson said. “We like the fundamentals.”

The improving picture for smaller companies comes as a relief to investors looking for ways to diversify out of the megacap technology stocks that have led markets higher for most of the past decade, with the top five companies alone making up more than 23-per-cent weight in the S&P 500.

“Now you don’t have to be in a FAANG stock to get some reasonable growth,” said Mike Petro, portfolio manager of the Putnam Small Cap Value Fund, using a common acronym for massive tech and growth stocks such as Apple Inc. and Amazon.com Inc . “You could be in some forgotten, little small-cap stock and get reasonable nominal growth on that.”

Mr. Jacob of Jacob Asset Management has pared back holdings in megacap stocks Alphabet Inc. and Facebook parent Meta Platforms Inc., while favouring smaller companies such as OptimizeRx Corp. and Digital Turbine Inc.

Some investors remain wary of small caps, which over the past decade have lagged over all, with the Russell 2000 rising 230 per cent against a 285-per-cent gain for the S&P 500.

Signs that yet another wave of COVID-19 is taking a greater hold in the United States, as it has in some European countries, could once again push investors out of economically sensitive stocks and into tech companies, which are expected to better weather short-term growth fluctuations.

Strategists at the Wells Fargo Investment Institute this past week urged investors to take profits on gains in “lower-quality” small-cap stocks and move into larger-capitalization companies, saying the economy is entering the middle phase of its expansion where growth historically has slowed.

Others, however, believe they could be a haven of sorts if tax policy changes backed by the Biden administration are put into law, in particular a minimum 15-per-cent tax on companies making more than US$1-billion.

Should that happen, “the impact on small-caps could be less than on large-caps,” said analysts at Ned Davis Research, which recently began favouring small-cap stocks.

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