The stock market didn’t produce the returns investors were hoping for in 2022. Many of the initiatives that helped the stock market during the pandemic created headwinds that played out in 2022. Historic stimulus saved the market in March 2020, but all of that spending produced scorching inflation at levels investors hadn’t seen in over 40 years.
Major indexes like the Nasdaq 100 and S&P 500 shed a lot of their value in 2022, but microcap investors didn’t feel as much pain. While the QQQ, an Invesco fund that follows the NASDAQ 100 Index, fell by over 30% in 2022, growth stocks in these indexes had larger losses, especially the pandemic darlings that achieved incredible price growth in 2020 and ended up with lofty valuations that cratered last year.
During this same year that saw many assets nosedive, microcaps didn’t do as bad. RZV, an Invesco fund that tracks the S&P SmallCap 600, was down by 8% in 2022.
With 2022 behind us and a new year ahead, many of the same problems remain. Inflation is cooling, but it’s still high compared to historical standards. The Fed is raising interest rates at a slower pace, but those rates are still going up. The Fed can’t control the supply side, and supply chain issues still present an obstacle. Microcaps outperformed larger cap investments in 2022, but can this success carry into 2023? Here are some reasons to believe small caps can continue their recent trend of outperformance.
Small Caps Have Better Valuations
An unrealistically high valuation can turn a great company into a bad investment. Similarly, a great valuation for a good company can yield great returns. Small caps currently boast better valuations than their large cap peers. RZV has a P/E under 11 and a P/B of 1.02. A P/B ratio under 1 usually indicates an undervalued company, and the P/E is also well below the S&P 500’s modern average of 19.6.
Compare that with QQQ, which has a 25 P/E and a P/B hovering near 6.5. There’s more room for the Nasdaq to fall as earnings continue to decelerate and some companies post negative numbers. The pricey NASDAQ 100 Index can still fall based on valuation and a slowing economy, but the more reasonable valuations of microcap assets give them a greater margin of safety. If the NASDAQ 100 Index had the same P/E and P/B as the S&P SmallCap 600, the conversation around valuations and appreciation potential would be different.
Those Valuations Could Be Lower for a Reason
Many investors pay premium valuations to get companies with promising futures. While some microcap stocks can outperform large cap peers, smaller companies have more fragile balance sheets. Although RZV outperformed QQQ in 2022, the 5-year charts look different, with the Nasdaq 100 Composite holding a comfortable lead over the S&P SmallCap 600. Microcaps also had a much smaller run-up from the pre-pandemic lows, giving them a greater margin of safety in 2022 than their large cap counterparts.
A Fed Pivot Favors Microcaps
As with so many investments, microcap’s outlook for 2023 largely depend on what the Fed does. Gregory J. Ferone, a CFP with Royal Alliance Associates, believes microcap investments stand to gain more from a Fed pivot than large caps. He is confident in the Fed pivoting in H2 2023 but cautions microcaps would face an uphill battle without the pivot.
“If the Fed stays their ground, you’ve got less probability of microcaps outperforming,” he said. “If the Fed does not pivot, large cap and value companies would outperform. I think the Fed will pivot, and I think small caps will outperform large caps.”
Small Cap Companies Have More Growth Opportunities
Most small caps have valuations between $250 million to $2 billion. If any of these stocks has an additional $500 million added to their market cap, it will produce noteworthy returns for investors. A $500 million increase in Apple’s market cap would not generate as much fanfare. Maturing companies can still perform well and stay in business for many years, but as they exhaust more of their market share opportunities, they become more vulnerable to declining stock prices. Historically low interest rates and strong investor confidence before the pandemic and upon the Fed’s intervention allowed mature companies to see stock price growth despite low revenue and earnings growth.
Facebook, now known as Meta, is the poster child of this trend. Meta reached a trillion dollar valuation at its peak but has since stumbled by over 70% to its trough in 2022. Revenue and net income were both down year-over-year for an ad-reliant company that depends on a floundering virtual universe concept in a desperate attempt to find new growth opportunities. Even if the company sticks with ads and rebounds, it becomes harder every year to post strong growth.
This is nothing new. Companies can have stronger revenue and earnings growth when they are smaller and still have large, unaddressed markets. However, it becomes more significant when investors start focusing on balance sheets and business models again. During economic challenges, investors take a closer look at valuations and what their business looks like right now rather than what it can become.
Facebook already has approximately 3 billion users. They can still increase ARPU, but most of the addressable market has accounts with them or knows of the platform’s existence.
Compare that with small cap valuations and the opportunities in the space that helped them outperform larger companies in 2022. Greater margins of safety and available catalysts can help small cap stocks outperform their larger counterparts in 2023, but investors should keep an eye on the Fed. While microcap valuations look more attractive than other investments, a prolonged economic recession can intensify pressure on microcap corporations that burn cash or operate on low profit margins.
