“A period like August creates a buying opportunity for us,” said Wetherell, who manages a fund at Cozad Asset Management dedicated to small-cap stocks, generally defined as those whose total market value is less than $3 billion.
Small-caps tend to outperform their larger counterparts when the economy is expanding and underperform when it’s shrinking. In the August sell-offs, they were walloped. To investors like Wetherell, that makes them all the more attractive.
While the jury is out on whether the nation is heading for a double-dip recession, the opportunity in these oft-neglected stocks has sparked a lively debate among professional investors.
“If we’re not in an economic recession, we could see a decent rally in small-cap stocks,” said Steven DeSanctis, small-cap strategist at Bank of America Merrill Lynch in New York.
Small-cap stocks have lost so much value this year — about 25 percent since their late-April peak, as measured by the small-cap Russell 2000 index — that DeSanctis thinks “flat is the new up”: If they simply end the year where they started, investors will see about a 13 percent rally from where they are now. Large-cap stocks slid about 18 percent in the same period.
Bank of America sees a 40 percent chance of recession, he added.
“That’s really the question that people have to answer for themselves — ‘Do we think a recession will occur?’ ” said Matthew Litfin, a portfolio manager at William Blair who invests in small- and mid-size companies.
Economists have grappled with that possibility in recent weeks. In late July, the Commerce Department said the economy grew at snail’s pace of 1.3 percent in the second quarter and revised its first-quarter estimates to 0.4 percent. A spate of weak reports on manufacturing followed. Then came gloomy figures on housing and consumer spending. And Friday, Commerce revised the second-quarter growth number down to 1 percent.
Not surprisingly, many economists say the odds of recession increased significantly in the past three months. But few are ready to call it — and therein lies the opportunity, experts say, for some diversification into small-cap stocks, best accessed through mutual funds.
Small firms tend to get hit much harder than big ones during economic downturns because they often have less diversified businesses and less cash on hand. That, in turn, gives banks second thoughts about lending them money, which can slow their growth even more.
“It’s very hard for them to get credit and capital,” said Chris Hanaway, portfolio manager at Wells Fargo Advisors. “If we go into another global recession, they will suffer disproportionately.”
The opposite is true in good times. Small companies tend to be at an earlier stage of growth than their bigger counterparts. “It’s the law of large numbers,” said Gary Lenhoff, director of small- cap strategy at Great Lakes Advisors. “It’s harder for IBM or Microsoft to grow as fast — they already have revenues measured in the billions.”