Many investors bemoan missing historic buying opportunities…

• Like in March 2020: Not buying after the pandemic-induced sell-off meant missing out as large caps rose 45%, and small caps surged 130%. In a year.
• Like in March 2009: Not buying once the bottom was finally put in following the Financial Crisis meant missing out as large caps soared 60%, and small caps rallied 110%. Again, within about a year.
• And like in September 2002: Not buying when the dot-com bubble deflated meant missing out as large caps rallied about 40%, while small caps rose nearly double that amount over the next two years.

Why am I bringing this up? It’s simple, really…

If we don’t act soon, chances are we’ll look back on September 2022 as yet another missed historic buying opportunity.

Let me explain…

Data Don’t Lie

A fresh analysis out of the number crunchers at Bank of America reveals that the selling in stocks, particularly small caps, is completely overdone.

In fact, we haven’t seen small caps this cheap in two decades, since the dot-com bubble burst.

More specifically, following August’s broad market sell-off, small caps have been beaten down to an average valuation of 11.8 times projected earnings.

For perspective, that’s about 20% cheaper than the long-term average valuation since 1985.

Relative to large caps, small caps have been beaten down to historically low levels, too. They now trade at a relative forward price-to-earnings ratio of 0.70.

For perspective, that’s 30% below the long-term average of 1.01, as you can see below. And the cheapest since the dot-com bubble, as well.

Three Key Takeaways

These extreme data readings shouldn’t come as a total surprise, of course.

Why? Because I’ve been calling your attention to the increasingly compelling case for small caps for a few months now (see here and here).

It’s that now we’ve finally hit a critical buying point. That is, as long as you know where to focus.

With that in mind, here are three key takeaways that should guide our investments in the months ahead…

Takeaway #1: The bottom’s in and big returns will follow

As Bloomberg notes, “Broader markets don’t bounce higher until small cap stocks bottom.”

That’s historically been the case, so there’s no reason to believe this time will be any different. And that’s good news!

Why? Because small caps clearly put in a bottom on June 16 and rallied 24% off the low. And right on cue, large caps rebounded, too, which I recently noted (see here).

The even better news?

With the bottom for stocks in, the current valuation for small caps implies they’ll rally much more than large caps over the next decade: 12% per year versus only 8% per year for large caps, according to Bank of America’s analysis.

In other words, the biggest gains in stocks over the next decade will likely come from small caps, not large caps. With one caveat…

Takeaway #2: Stock picker’s delight

As I shared recently on a Fox Business appearance, simply buying an index fund like the iShares Russell 2000 ETF (IWM) and hoping for the biggest returns won’t work. Why? Because we’ve transitioned into a stock picker’s market.

So while all small caps are poised to rally, certain small caps should rally the most. Which ones? We’ll get to that in a moment.

First, it’s important to realize I’m not alone in my conviction here.

As Jill Carey Hall, equity and quantitative strategist at Bank of America noted, “Very elevated valuation dispersion within the Russell 2000 overall” suggests “more opportunity for stock selection.”

Indeed!

Takeaway #3: High-probability, undervalued opportunities abound

The extreme valuation disconnects mean small-cap value stocks stand to rally the most.

That’s because the Fed isn’t going to let up on raising interest rates, which drags down the return potential for growth stocks.

Even if we ignore the Fed’s impact and simply look at past valuation dispersions between small caps and large caps, the Russell 2000 Value Index handily outperforms the Russell 2000 Growth Index over the next three months a full 70% of the time.

In the simplest terms, there is “lots of opportunity” for small-cap value investors, according to Carey Hall. And I couldn’t agree more!

If you want to invest in the most undervalued and target-rich area of small-cap value stocks, focus on the energy sector. Bank of America’s analysis notes that the group remains the most inexpensive versus historical averages, and in comparison to large caps.

In other words, they represent the lowest-risk, highest-probability investments in the current market. So don’t miss out (again) or you’ll be bemoaning it in short order.

Ahead of the tape,

Tags: buy small-cap-stocks