Wells Fargo flashes green light on small caps

syahrir maulana

Wells Fargo said Monday that it now believes that small-cap stocks will outpace their large-cap counterparts in the near term, noting more attractive valuations and a faster adjustment of the group's earnings expectations in the face of changing conditions.

In a note to clients, the firm noted that it had previously turned positive on small-cap growth in February. However, Wells Fargo has now expanded that view to include the broader small-cap universe.

"Last year we said small-cap Quality was historically mispriced, but did not think the macro environment favored small caps over large caps," the firm noted. "Going forward, we still believe in a High Quality approach, and we now expect small caps to outpace large caps."

Wells Fargo gave three reasons for broadening its call. First, the group is currently technically oversold, although they have begun to experience a "bounce."

Second, the valuation premium of the Russell 2000 Index (RTY) compressed to about 20%. This compares to a figure of about 50% for the broader market (SP500) (SPY).

Third, Wells Fargo estimates that EPS revisions for small-cap names have "beaten the rush," coming down faster than for large-cap stocks. "In general, we are taking a 'FIFO approach' to EPS revisions and believe companies that are already managing down expectations offer a slightly better risk/reward, all else being equal," the firm said.

In terms of specific names, Wells Fargo announced some changes to its Quality Small Cap portfolio. This included adding Ollie's Bargain Outlet Holdings (OLLI) and Brookfield Renewable Corp (BEPC), as well as increasing positions in HERC Holdings (HRI) and Terex (TEX).

Meanwhile, the firm is removing Greif (GEF) and Century Communities (CCS) while trimming its weighting in IONS Pharmaceutical (IONS).

Here's a list of small-cap ETFs: (VBR) (SCHA) (VBK) (IWO) (FNDA) (DFAS) (AVUV) (DFAU) (DGS) (IJS)

For another bullish take on the small-cap sector, Bank of America argued that small caps will likely benefit over the next few years as the 2020s continue to resemble the 1970s.