We’re well into the new year now, and investors are naturally wondering which investments will prosper in the months ahead. With the Magnificent 7 stocks (that is, Alphabet, Amazon, Apple, Meta Platforms, Microsoft, NVIDIA and Tesla) making up the bulk of 2023’s market gains, many are expecting broader participation from the rest of the market.
Small-caps in particular seem overdue to outperform. Their rally at the end of the year might seem to be confirmation of that idea, but even with the year-end push, small-cap stocks are trading at a significant discount.
I know it’s tempting to dive in. But investors should always be aware of risk. That’s particularly true if you’re retired or close to retirement. Simply put, you don’t have much time to make up for mistakes. And getting overly excited about small-caps could be a mistake.
Sign up for Kiplinger’s Free E-Newsletters
Profit and prosper with the best of expert advice on investing, taxes, retirement, personal finance and more - straight to your e-mail.
Profit and prosper with the best of expert advice - straight to your e-mail.
Cheap stocks are often cheap for a reason. That certainly appears to be the case with small-cap stocks today.
Larger companies more likely to have lower rates locked in
For starters, there’s debt. Generally, bigger companies have much less debt maturing in the near future. Over the past few years, the majority of U.S. homeowners locked in low-rate mortgages. They will enjoy the benefits of that decision for years to come. It’s the same with large companies that have locked in long-term debt at favorable rates.
Smaller companies, on the other hand, don’t have the same access to bond markets for raising long-term debt. They generally use bank lines of credit and shorter-term sources of liquidity. That means their debt is being repriced at substantially higher interest rates, which is a headwind to profits.
Average Interest Rate Paid on Debt
Source: Wisdom Tree, FactSet, MSCI, as of 9/30/2023. Excludes financials sector.
As shown in the chart above, the interest cost over the past year for large-cap companies (S&P 500) is notably lower than for small-cap companies in the S&P 600 and Russell 2000. For weaker companies, higher rates could mean the difference between being profitable or in the red, especially in a recession.
Many smaller companies are unprofitable
Speaking of in the red, did you know that 40% of companies in the small-cap Russell 2000 index are unprofitable today? And that’s with a pretty strong economy. For now. Consumer credit card delinquencies and auto loan defaults are spiking. Bankruptcies are on the rise, as are delinquent commercial real estate loans. These are certainly signs that we may be in for more challenging times, if not an outright recession.
Higher rates plus a slowing economy could mean a spike in bankruptcies in the small-cap universe. But there’s good news: There are some great small-cap stocks out there! Not every small-cap company is drowning in debt, and in some niche areas, smaller companies can be industry leaders. They’re often overlooked — especially in an environment like today when the biggest stocks are getting all the attention.
If you are a roll-up-your-sleeves investor (or have a financial adviser who is), you may be able to find some wonderful businesses at attractive prices. However, if you or your adviser are the type to buy mutual funds and ETFs that own hundreds of positions, be careful. If those funds are broadly invested across the small-cap universe, you may be exposed to a collection of unprofitable and highly levered companies. If we head into slower economic times, what looks cheap today may cost you dearly.
Related Content
-
Ask the Editor — Reader Questions on Gifts, Estate TaxIn this week's Ask the Editor Q&A, we answer tax questions from readers on gifts, the estate tax and stepped-up basis upon death. In our latest Ask the Editor round-up, Joy Taylor, The Kiplinger Tax Letter Editor, answers questions on gifts, the estate tax and stepped-up basis upon death.
-
Get a Free Will or Trust, Online, in Under an HourCreate a state-specific, attorney-approved will or living trust — at no cost and in less than one hour — with Fifth Third Bank.
-
Five Reasons Roth Conversions and Pensions Work Well TogetherThis financial planner unpacks why Roth conversions can save you big-time on taxes if you're a retiree with a pension.
-
The One Surefire Way to Keep Your Car Insurance Premium From SoaringI'm an insurance expert, so I know from extensive experience: The more claims you file, the higher your car insurance premium. So maybe don't ask your insurer to fix that tiny scratch on your bumper.
-
What You Expect in Retirement vs What You Get: Where Reality Can Surprise YouA financial planner explores how your expectations for retirement can greatly differ from reality — and how you can plan for that.
-
What's Up With the 10-Year Treasury Bond: Four Financial Experts Weigh InA financial professional and three colleagues explain the fluctuations in the 10-year Treasury bond and what investors should do.
-
Time to Spring-Clean Your Finances: A Financial Professional's Four Steps to Tidy Them UpA midyear review of everything from spending to saving, with adjustments as needed, can set you on track to financial security. Plus, don't forget to check in on your workplace benefits.
-
Why a Law Firm Secretly Recording Client Conversations Is Wrong (and Illegal)A law firm that has been recording client conversations without the clients' knowledge or permission and has threatened employees if they speak out faces legal and ethical challenges.
-
Donating Complex Assets Doesn't Have to Be ComplicatedIf you're looking to donate less-conventional assets but don't know where to start, this charity executive has answers, such as considering a donor-advised fund (DAF) for its tax benefits and ease of use.
-
Think a Repeal of the Estate Tax Wouldn't Affect You? WrongThe wording of any law that repeals or otherwise changes the federal estate tax could have an impact on all of us. Here's what you need to know, courtesy of an estate planning and tax attorney.
