5 Reasons to Buy Micro Cap Stocks Now

Deglobalization to accelerate what is already an ideal environment for small companies to shine

Nov 20, 2023

Some of the biggest gains in the stock market over the next decade will come from companies that virtually no one is covering. While the media is consumed with big tech and AI, the biggest opportunity for substantial gains in the stock market is in small and micro cap stocks.

Here are our top 5 reasons investors should consider micro cap stocks:

1. Micro cap stocks are extremely undervalued

Micro cap stocks have never been more cheap relative to large cap companies, a historic anomaly that will not last indefinitely.

The iShares Micro-Cap ETF (IWC) is trading at a P/E ratio of 8.49, less than half the P/E ratio of the S&P 500 ETF (SPY). Micro caps are even cheaper on a price/book basis, indicating future returns for small companies are likely to be higher than the rest of the market.

Historically, stocks with P/E ratios below 10 deliver subsequent 10-year annualized returns of 16.5% (vs. 9.5% 10-year annualized returns for P/E ratios above 18).

This means investing $10,000 into micro caps now could grow to over $50,000 in 10 years, vs. only $26,000 if invested in large cap companies.

2. Micro caps deliver better risk-adjusted returns when added to a diversified portfolio

Micro cap stocks increase your portfolio’s risk-adjusted return because they aren’t highly correlated with other asset classes, including other U.S. stocks, foreign stocks, gold, oil and bonds.

Small companies tend to move independently of other asset classes and allocating part of your portfolio to smaller company stocks can deliver a more stable return profile with lower volatility. In fact, some of the best days for our micro cap portfolio occur on lousy days for the S&P 500.

Source: ETFScreen.com

3. Small companies outperform during inflationary times

Investors are hesitant to buy small company stocks during inflationary times because they are thought to have less pricing power than large caps.

But a report from Global investment company Abrdn shows that small companies deliver excess returns over large caps even during periods of high inflation (+3.5% when the CPI is above 4%).

The Russell 2000 also has greater exposure than the S&P 500 to the Energy and Capital Goods sectors, which benefit from higher energy costs.

Source: abrdn

4. Deglobalization and infrastructure spending will disproportionately benefit small companies

In addition to the $1.2 trillion infrastructure bill, the U.S. government is also offering significant incentives to expand domestic manufacturing. Goldman Sachs estimates that the Inflation Reduction Act along could spur up to $11 trillion in total infrastructure investment through 2050.

Small cap sales growth is highly correlated with U.S. capex growth, mostly because small companies tend to be domestically focused. According to Bank of America, sales growth for U.S. small-cap firms is 85% correlated with CapEx growth for Russell 2000 and S&P 500 companies, compared with 76% for large-cap companies.

The move toward deglobalization and the additional spending to upgrade the country’s infrastructure will provide a massive tailwind for small company stocks for at least the next decade.

5. Micro caps are one of the few areas of the stock market where individual investors have an edge over Wall Street

The micro cap universe is ignored by Wall Street, slowing down the process of price discovery and therefore making it easier to buy undervalued companies before the market notices.

Portfolio managers investing with billions of dollars tend to ignore micro caps, because it’s not practical to invest in companies that represent such a small percentage of assets under management.

Research from Oberweis Asset Management shows that the average small cap manager had nearly 53% of their portfolio invested in companies with market caps under $1.5 billion in 2012. That allocation dropped to 24% in 2022.

This allows valuation inefficiencies to persist, presenting an incredible opportunity for disciplined investors to build wealth.

The Predictive Investor