In 2015, Little Is The New Big

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by: Nicholas Vardy

Editor's note: Originally published on 24 February, 2015

When it comes to stocks, “big” is sometimes little — and “little” is sometimes big.

Here I’m referring here to the recent performance of small-cap stocks versus large-cap stocks.

Small caps include stocks with a market capitalization of between $300 million and $2 billion. The bulk of these companies are ones you probably have never heard of.

Large-cap stocks consist of stocks with a market cap of more than $10 billion. These stocks make up a huge chunk of the S&P 500 and include all of the household names you know.

Diverging Performance

Large-cap and small-cap stocks differ not only in size, but also in terms of performance. In 2014, large-cap stocks meant big returns, with the SPDR S&P 500 ETF (NYSEARCA:SPY) posting double-digit percentage gains of nearly 12%. By way of comparison, returns to the small caps were indeed little, as stocks in the small-cap SPDR S&P 600 Small Cap ETF (NYSEARCA:SLY) eked out a mere 1.3% gain for the calendar year.

No wonder investors withdrew $31.5 billion from small-cap stocks over the past 14 months, according to research firm EPFR.

So far in 2015, the playing field for both big and little stocks has been far more level. The S&P 500 has pushed its way to a 2.75% gain so far this year, while both the S&P 600 and the iShares Russell 2000 (NYSEARCA:IWM) are up 2.4% year to date.

While these two market segments are running neck and neck so far in 2015, I expect small caps to overtake their large-cap rivals between now and the end of the year.

And I’m not alone.

The latest weekly data from EPFR showed that investors increased inflows into small-caps by $31 million — a trickle that I expect will turn into a flood before the year is out.

The Small-Cap Tailwinds

In 2015, small-cap stocks have the wind at their backs.

First, after a year of underperformance, small caps now trade at far more attractive relative valuations than their big-cap brethren. The S&P 600 now trades at roughly 20.3X forward 2015 earnings. That’s much lower than the trailing 20-year average, and well below their level at the start of 2014. In contrast, large-cap stocks have rarely been this expensive.

Second, there’s the relative strength in the U.S. economy. Growth in the U.S. economy — whether measured by gross domestic product (NYSEMKT:GDP), employment numbers, manufacturing PMIs — is a boon for small-cap companies. The reason here is quite simple. Most small-cap companies are purely domestic businesses whose fate is closely tied to the U.S. economy. U.S. small caps have few, if any, international operations.

That means small caps are immune to the drama playing out with Greece and the European Union, the tenuous ceasefire between Russia and Ukraine and the attempt by the European Central Bank to reflate its sagging economy via the Old World version of quantitative easing.

It is the big guys — the large-cap multinationals — that make up the S&P 500 and sell much of their goods to Europe and the Far East, which are suffering from these challenging developments.

But the biggest headwind for large caps is the stronger greenback, which is dampening revenues and earnings for big-cap stocks. A stronger dollar has already hit the revenues of 70% of the top 50 companies in the S&P 500 hard.

A True Growth Play with Biotech Leanings

For stocks prices to rise, earnings have to grow. And here again, big is little and little is big. And in 2015, U.S. small caps offer investors far better revenue growth prospects than their large-cap rivals.

According to Bloomberg, sales per share are estimated to increase 6.6% this year for the small-cap stocks in the S&P 600. In contrast, the large-cap stocks in the S&P 500 are expected to see sales per share edge higher by a puny 0.1%. Bank of America Merrill Lynch is even more pessimistic and expects overall S&P 500 earnings growth to be flat in 2015.

The outlook for small caps is much stronger in 2015. Much of that is due to red-hot sectors like biotech, which is chock full of high-performing small caps. The iShares Nasdaq Biotechnology ETF (NASDAQ:IBB) is already off to a stellar start in 2015, having vaulted to an 11.4% gain so far this year.

Increased merger and acquisition activity in the biotech space, along with an increased buzz about new drug therapies, has investors piling in to these small-cap stocks. In this way, biotech has picked up right where it left off last year. Over the past year, five of the top 10 best-performing companies in the Russell 2000 were biotech firms.

So, what’s the moral of the story?

Bet big on small caps in 2015. Little is the new big.

Disclosure: No positions