Fidelity Monitor & Insight: The Case for Small Caps

06/19/2018 5:00 am EST

Focus: FUNDS

John Bonnanzio

Editor, Fidelity Monitor & Insight

In the ongoing tug of war between large- and small-cap stocks, the latter has recently gotten the upper hand, asserts John Bonnanzio, fund expert and editor of Fidelity Monitor & Insight.

Whereas small-caps out-sprinted large-caps by over nine percentage points in 2016, last year, big caps outpaced small caps by seven percentage points. Investors preferred large caps for two main reasons:

1. Global economic growth was strong, and large caps were seen as best positioned to benefit from that expansion;

2. On top of that, the dollar had been weak, making U.S. goods and services more attractive abroad, favoring large exporters.

But large-cap-lust started to wane in March, as investors grew concerned that economic growth in Europe and Japan was slowing.

Add to that concern, White House rhetoric on tariffs, trade wars and embargoes, and investor angst over big caps accelerated: Small-caps outpaced large-caps by nearly four percentage points in March.

But with such concerns rising and falling daily, the performance difference between the large-cap S&P 500 and the small-cap Russell 2000 was a slim 0.7% in favor of the latter through the first quarter.

Since then, small-caps have expanded their edge, particularly in May (up 6.1% versus 2.4%). For the year-to- date, Small Cap Index is up 6.9% versus 2.0% for the 500 Index fund.

On the valuation front, the S&P 500’s price-to-earnings ratio (P/E) remains relatively more attractive (less expensive) than small caps. That’s despite the fact that big tech companies are selling at a premium (owing to their faster earnings growth) to other sectors.

But there’s another side to tech’s P/E expansion: Roughly half of the S&P 500’s 21.8% gain last year was fueled by only 17 big-cap stocks — nine of which are giant tech firms. So, it’s not unreasonable to think that further P to E expansion (appreciation) may be harder to come by.

Moreover, after last year’s large cap outperformance, their valuation advantage has narrowed. Another plus: The 5-year earnings growth rate for small caps is projected to be about six percentage points higher than their larger brethren. That’s not surprising.

After all, small-caps tend to grow faster than bigger caps. But that inherent advantage may be accelerating as corporate giants have found themselves victims of diminishing consumer loyalty, and thus are finding it difficult to raise prices.

In the shorter term, the appreciating dollar (it rose 1.7% in May and is up 1.2% this year) is less of a headwind for domestically focused small-caps than for larger firms with significant exports. Taken together, the price premium still afforded to large-caps may be eroding, leaving small-caps with an opportunity to move ahead.

We have upgraded our ratings on five small-cap funds:

Fidelity Small Cap Enhanced Index (FCPEX)
Fidelity Small Cap Growth (FCPGX)
Fidelity Small Cap Index Fund (FSSVX)
Fidelity Stock Selector Small Cap (FDSCX)
Fidelity VIP Disciplined Small Cap (FIAGC)

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