Our view on small-cap stocks | BlackRock Target Allocation

Key takeaways

• Small-caps have been saddled with debt as leverage trended up in the last decade, dampening their benefits as a buy-and-hold.
• But we see reasons to own small-caps selectively with a more dynamic approach, trading on tailwinds rather than owning long-term.

Small-caps have been viewed as persistent winners since the ‘90s because their higher risk-premium led to historical outperformance. We think this return anomaly has faded.

When the small-cap anomaly started to gain notoriety, large firms had relatively more debt and made more acquisitions that often weren’t accretive to earnings. These bloated conglomerates made small and nimble firms attractive, but we’re now in a different era.

Since the Great Financial Crisis, large-caps de-levered and got their debt under control because… well, they had to. Smaller firms saw their debt relative to earnings actually increase. Small-caps have been saddled with debt as leverage trended up in the last decade, dampening their benefits as a buy-and-hold.

On the other side of the equation, large-caps benefited from the internet’s price transparency. Large-caps have economies of scale: shrinking per unit costs as firm size grows. Competition became more direct as the internet made price comparisons fast and easy, making low unit costs even more advantageous.

Big firms have an outsized benefit from internet adoption, and the rise of big tech made large-caps even more attractive. Tech firms in the modern era enjoy wide moats because channels to access the internet – social media, search engines, devices – gravitate towards concentration rather than market fragmentation.

But just because small-caps lost their edge doesn’t mean that we shouldn’t consider investing. We see reasons to own small-caps selectively with a more dynamic approach, trading on tailwinds rather than owning long-term.

Companies have been staying private for longer, according to Nasdaq. Rather than issuing public stock, private companies have received more financing from venture capital firms in the 21st century than in the last.

The development of larger private markets took some breakout growth opportunities away from stocks and shifted some of those gains to private shares. If the IPO market re-emerges from its current winter, we believe that the stock market could capture more early growth as smaller firms go public sooner.

Small-caps could also see tailwinds from rate cuts, which could lower the cost of their relatively high debt burden. If we see the Fed move faster than markets anticipate on the way back down, those moves could provide upside for debt-laden firms.

Temporary supply disruptions have also benefited smaller stocks in the past. Because large-caps disproportionately rely on global supply chains, supply shocks and trade disruptions can serve as a boon for firms that source domestically.

These forces could create tradable events and sector trends. It’s not that small-caps have lost their potential, our analysis indicates that they can be great investments when bought at the right time. So for now, small-caps are on my watch list as a periodic vehicle.

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