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Investment Strategy

Bottom’s Up: Small Caps are a Buy

By Elliott H. Gue, on Jun. 21, 2014

Many small- and mid-cap stocks simply don’t trade with enough liquidity for big institutions to move in and out of positions with ease. Instead, traders at these institutions tend to buy large-cap names that trade in higher volumes or diversified baskets of stocks tracking individual sectors or markets.

But individual investors don’t have to mimic these trading strategies; in fact, flexibility and nimbleness are huge advantages. Don’t settle for subpar returns. You can focus on owning the best stocks within a particular group, regardless of their market capitalization.

And right now, the small-cap segment offers investors an under-the-radar opportunity for investors who don’t mind doing some digging.

Last year, the S&P 600 Small Cap Index outperformed the S&P 500 by a margin of 9 percent. And over the past five years, the small fry have outpaced the S&P 500 by almost 30 percent.

Although small-cap stocks have underperformed thus far in 2014, we regard this weakness as a healthy bout of profit-taking within the context of a bull market.

Moreover, claims that the S&P 600 Small Cap Index appears overvalued reflect nuances of index construction, as opposed to a meaningful trend.

With a total market capitalization $18.8 trillion, the companies in the S&P 500 dwarf the $750 billion float of the 600 names in Standard & Poor’s small-cap index.

Important differences in sector allocations also contribute to the underperformance of the S&P 600 Small Cap Index relative to the S&P 500.

Financial Sector: Underperformance of Regional Banks

Financials account for about 22 percent of the S&P 600 Small Cap Index, compared to 17 percent for the S&P 500.

The performance gap between large- and small-cap financials has widened this year, with names in the S&P 500 up 5.1 percent on a capitalization-weighted basis and their counterparts in the S&P 600 up 2.3 percent.

Bank of the Ozarks (NSDQ: OZRK) and UMB Financial Corp (NSDQ: UMBF) are key members of the S&P 600’s financial segment, while mega-banks such as Bank of America Corp (NYSE: BAC) and other large financial-services firms drive the S&P 500.

The S&P 600 Small Cap Regional Banking Index has tumbled by 2.7 percent this year, after soaring 51.6 percent in 2013. In contrast, the KBW Bank Index, which comprises money-center and major regional banks, gained almost 38 percent last year and has rallied by 3.6 percent this year.

This performance gap reflects some profit-taking after last year’s run-up in small-cap financials, a trend that has an outsized effect on the S&P 600 because of sector’s higher weighting relative to the S&P 500.

As a rule of thumb, regional banks also tend to do well when the yield curve steepens. Financial institutions pay depositors interest based on short-term rates, but lend money at long-term interest rates. When the spread between long- and short-term interest rates widens, these smaller banks’ profitability tends to rise.

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