Microcap stocks are still the one reliable sector of the market where investors can expect above-average returns even in an environment of rapidly rising interest rates. Decades of data back up this observation.
While inflation concerns remain part of the picture, the strength of the economy could continue to drive robust performance for microcap stocks.
An analysis of microcap stock performance since 1962 shows an average gain of 25% in 10 of the 12 periods when the Federal Reserve raised interest rates. Data from the Duff & Phelps’ Ibbotson Annual Yearbook shows that microcaps outperformed other markets in average two-year periods during a rising interest rate environment.
But why?
“One important factor influencing these returns is the lower levels of debt,” Acuitas Investments observes in an investor note. “Rising rates often occur during periods of economic growth where some of the greatest opportunities to leverage the improving economy is through smaller stocks. Larger stocks with higher levels of debt and lower growth rates have not historically kept pace.”
A data point worth noting: Despite severe inflation in the late 1970s, the strength of the economy drove the performance of microcap stocks to a gain of nearly 84% from January 1977 to March 1980, when the Fed began to ease back on monetary policy at the onset of the Reagan era. This is when the trend began to reverse itself, and large-cap companies started to outperform relative to microcaps.
“Small and microcap companies, with smaller and often less diversified businesses, do not possess the same ability to borrow money in the credit markets,” notes Acuitas. “In addition, smaller companies retain greater future flexibility by retaining low levels of debt. As a result of these lower levels of debt, small companies do not benefit to the same degree from a reduction in borrowing costs.”
This suggests that now is the time to consider pumping money into thoughtfully-chosen microcap stocks while interest rates remain high.
While the Fed has already raised the target rate eight times during this current tightening cycle, it’s easy to spot when markets really took notice that the central bank wasn’t fooling around that it was about to recalibrate monetary policy. It was November 2021 when cryptocurrency and many of the riskiest stocks peaked.
While short-term traders may be sweating rising rates and trying to gauge the timing of a recession, if it ever comes, a little perspective is in order. Instead of fretting over the right time to sell, buy-and-hold investors can use market volatility to their advantage, concentrating instead on finding the right time to add more to their portfolios.
In a rising interest-rate environment, market pullbacks represent attractive buying opportunities for buy-and-hold investors. Stocks are almost always cheaper when few can agree that they’re an attractive investment.
Since the Russell 2000 began tracking the performance of small-cap stocks in 1979, the index has broadly matched, if not slightly exceeded, the performance of the venerable S&P 500 index of large-caps. Now, to be clear, since early 2014, the S&P 500 has outperformed the Russell 2000 by about 55%, although these results occurred in a low interest-rate environment that tends to favor large companies as we have seen. Now the times are changing.
Yet what if the markets in the next six months actually defy history and microcap valuations do plummet? The smart investor will still look for quality companies that have unique competitive advantages and trade below their potential. These are the stocks most likely to rebound when the markets turn around. History has shown this to be the case time and time again.
As Warren Buffett once said, “Opportunities come infrequently. When it rains gold, put out the bucket, not the thimble.”
