This Small Cap Rally is Just Getting Started

Lou Basenese

Thursday, November 19, 2020

Grammy Award-winning singer “Beck” once proclaimed, “Where it’s at, I got two turntables and a microphone.”

I say, forget about two turntables and a microphone — small caps are where it’s at!

In fact, the small-cap Russell 2000 index is on an absolute tear. It hit all-time highs this week and has surged 86% (and counting) off the market intra-day bottom in March.

That’s a full 28 percentage points better than the large-cap S&P 500 Index over the same time period.

Today, I'll explain why I expect this trend to continue...

And I'll show you one of the easiest ways to profit from it...

Bigger Isn’t Better

A host of factors are turning into strong tailwinds for small caps right now.

First off, we’re witnessing a surge in retail investment. Chalk it up to boredom during the lockdown, or the desire to develop a side hustle trading stocks. The data is undeniable.

Citadel Securities estimates that retail investors now account for as much as 25% of the stock market. That’s up from only 10% last year.

And these investors are gravitating toward lower priced, small-cap stocks.

It makes sense: why own a single share of Amazon for around $3,000 when you can buy 300 shares of a $10 stock… or 3,000 shares of a $1 stock?

Logical or not, the psychology of price matters and influences buying behavior.

At a more fundamental level, small caps are poised to directly benefit the most in the current environment.

Why? Because most of them derive the majority of their sales and profits in the United States. That shields them from geopolitical risks, which are coming to the forefront in run-up to a change in power in Washington D.C.

What’s more, the U.S. economic outlook is improving. And when GDP growth accelerates, small caps outperform — again because they’re more domestically concentrated.

More specifically, the analysts at Jefferies, an investment bank, expect GDP growth of 4% in 2021 – a rate which historically drives small caps up 17%, or about two full percentage points, higher than large caps.

Last, but certainly not least, small caps are ideal takeover bait. And merger and acquisition activity is perking back up.

In fact, in the last month of the third quarter, total M&A activity increased 45% to $325 billion, according to GlobalData.

This surging urge to merge isn’t going away, either. Why?

As Jefferies analyst Steven Desanctis recently explained to CNBC, “You need consolidation in the market… Scale matters. You need to be big to compete in this world, so if you’re not big enough you need to find a partner and get bigger.”

In other words, for large caps to keep growing sales and profits, they need to keep acquiring small companies. It’s the only way to bolster growth quickly.

So, what’s the best way to play this small cap trend?

An Under-the-Radar Option

The obvious plays are one of the largest and most popular small-cap ETFs like the iShares Core S&P Small-Cap ETF (IJR) or the iShares Russell 2000 ETF (IWM).

But forget about being predictable and following the herd.

Instead, I recommend you consider a more under-the-radar and undervalued option – the Royce Value Trust Inc. (RVT) closed-end fund.

Here’s why…

It’s the oldest small-cap closed-end fund, and is managed by Chuck Royce, the "Warren Buffett of small-cap investing." We couldn’t ask for a better person to be picking investments for us.

Speaking of stock picking, that’s a key drawback to investing in small-cap ETFs. They are passively managed, which means we buy the entire index of small caps and, in turn, own all the winners and all the losers.

But by going with RVT, we’re getting an actively managed portfolio with a solid stock picking approach. According to Royce, this approach “Combines multiple investment themes and offers wide exposure to small-cap stocks (generally market caps up to $3 billion) by investing in companies with high returns on invested capital, or those with strong fundamentals and/or prospects trading at what Royce believes are attractive valuations.”

The performance data proves Royce’s approach works. The fund has outperformed the small-cap Russell 2000 index — period.

Best of all, the fund is currently trading at a 13% discount to net asset value, which means we’re literally buying all the small-cap stocks in the portfolio on sale.

I don’t expect the bargain to last long, though. So don’t miss out!

Ahead of the tape,

Tags: profits small-cap-stocks