Canadian small cap names have outperformed their large-cap peers in recent months, but the upstaging is likely to be short-lived and investors should be cautious and selective about what they own, said BMO Nesbitt Burns chief investment strategist Brian Belski.
“There is no denying the recent outperformance of small stocks relative to their larger cap brethren over the last few quarters,” Mr. Belski wrote in an Oct. 22 report.
“While the outperformance is certainly encouraging after the consistent underperformance over the past few years, we are skeptical about the sustainability and believe it is likely premature to shift weight toward smaller capitalization names.”
The small cap underperformance reached an “extreme” six months ago, heading into March, he said, but adds small caps have been in a “decade-long underperformance trend” compared to large caps. “Recent outperformance is more likely a reversion from oversold levels, in our opinion,” Mr. Belski wrote.
The S&P/TSX Small Cap Index is up 45.9 per cent over the last six months, between March 31 to Sept. 30, “significantly outpacing” the S&P/TSX Composite Index’s 20.5-per-cent rise over the same period, Mr. Belksi pointed out.
It also outpaced the Russell 2000 Index — an index of the small public names listed south of the border — which was up 30.8 per cent over the same period. The S&P 500 was up 30.1 per cent.
The BMO Small Cap Index was up 47.2 per cent over the same six-month period, but that return dropped to 27.2 per cent with the removal of resource stocks. (The BMO Small Cap Index was down 1.7 per cent over the 12-month period ended Sept 30 and fell 7.2 per cent minus resources).
Mr. Belski said gold has been “the key source of strength,” in the past six months, with some stocks in that sector roughly doubling over the period. The price of gold has been surging as a haven for investors amid the economic uncertainty caused by the COVID-19 pandemic.
“Gold has a huge tailwind that has helped support and put an inherent bid in the small cap space,” he said in an interview. “If you strip out gold, it basically performs in line with the small-mid caps in the United States.”
“Given the gold centric nature of the Canadian small cap universe, we would need to see continued strength in these names for the broad small cap universe to continue to outperform at this pace,” he noted in the report.
And while small-cap earnings are expected to rebound in the coming quarters, Mr. Belski believes the “underlying fundamentals are more ‘mixed,’” especially compared to the large cap names.
“As such, we are cautious on small caps more broadly and believe investors should focus on bottom-up stock picking relative to relying on industry, sector, asset class, and stylistic driven conclusions,” he wrote.
Mr. Belski also said limited liquidity of small cap stocks is something investors should be mindful of.
“There aren’t a lot of names that .. have any kind of volume, or research following...,” he said in the interview, but added many do beat the market, which makes them worth considering.
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