Small-cap stocks have had a rough go of it this year, with the Russell 2000 small-cap stock index falling 20%.
So where are they headed from here?
“Bank of America economists forecast a mild recession starting now,” the investment firm's strategists noted in a commentary.
And “several of the most correlated indicators with small-cap returns have been deteriorating: purchasing-manager indices, consumer and small-business sentiment and leading indicators,” they said.
“We would be cautious on small-caps in the coming months, where we expect volatility and risk of further downside. But we would double-down on our preference for small-cap over large.”
While recessions are often worse for small-caps than large-caps, “this time, we think risks [for small-caps] are largely discounted,” the strategists said.
Weathering Macroeconomic Conditions
“Small-caps are better positioned to weather today's backdrop of higher-for-longer inflation, deglobalization, risks to covid beneficiaries (big growth stocks), and geopolitical risks.”
In addition, “small-cap corporations have been guiding [earnings] above consensus versus below average/deteriorating guidance for large companies,” the analysts said.
“Stagflation typically isn't good for equities, but small-caps have outperformed large.”
As for risk being priced into small-caps, the Russell 2000's recent 32% decline equals 89% of the average recessionary decline for the index, the strategists said.
The Russell 2000’s equity risk premium is at record highs. The equity risk premium is the excess return that investing in the stock market – in this case the Russell 2000 -- provides over Treasury securities.
In addition, the Russell 2000 forward price-earnings ratio is on par with prior recession lows, at 40% off the highs, compared to a 33% average in prior recessions. Also, the Russell 2000 p-e ratio is near record lows versus large-cap stocks, the strategists said.
Bank of America's List
Bank of America put together a list of small-cap and mid-cap stocks that can do well during a recession.
It combed the Russell 2000 and Russell MidCap indices for “stocks which screen well on attributes that have historically outperformed recession regimes, including high quality, cash return and low risk.” Cash return means dividends and share repurchases.
The stocks on its list that Bank of America analysts rate buy include:
· O’Reilly Automotive (ORLY), an auto parts company;
· Hershey (HSY), the candy company;
· Chemed (CHE), a hospice services company;
· Amphenol (APH), which makes electronic connectors;
· Vontier (VNT), an industrial technology company;
· ExlService (EXLS), a data analytics company; and
· Avery Dennison (AVY), which makes adhesive materials.
Morningstar’s Take on O’Reilly Automotive
“As the most fully realized exemplar of the dual-market (commercial and do-it-yourself) approach to auto-part retail, narrow-moat O’Reilly has capitalized on favorable industry dynamics to achieve strong returns,” Morningstar analyst Zain Akbari wrote in a commentary.
“The firm has profited from increases in miles driven and average vehicle age as well as the benefits of its expansive distribution network in ensuring part availability.”
