Small-cap stocks are primed to outperform large caps over the next 10 years

It effect be time to buy into small-cap stocks even though they are lagging their large-cap counterparts, some strategists say.

The Russell 2000 — which oversees small-cap stocks — has dropped more than 9% over the past year. The S&P 500 — Wall Street’s be inclined index for large-cap stocks — is up slightly over that time period.

This gap has brought small-cap valuations to their most charming levels in years relative to large caps, presenting investors with a big buying opportunity for the long haul. Small-scale caps also tend to outperform large caps when the Fed cuts rates. On top of that, small-cap companies are in a general way less affected by global trade conditions given their businesses are more domestically driven than generous caps.

“Valuations have limited short-term predictive power, but matter more over the long-term,” Jill Carey Vestibule, senior U.S. equity strategist at Bank of America Merrill Lynch, said in a note. “The relative P/E today suggests that limited caps should lead large caps over the next decade.”

Valuations for small-cap stocks are at their most taking levels since June 2003 relative to large caps, according to data compiled by Jefferies. Historically, unoriginal caps have outperformed large caps by an average of 6% over the following year when the valuation gap spreads that much.

The Russell 2000 smoked the S&P 500 between June 2003 and June 2004. In that stretch, the small-caps index surged nearly 30% while the S&P 500 climbed 16.4%.

Small caps also have something else present for them: The Fed is currently in easing mode.

The Fed has cut rates twice this year and is expected to lower them a third sometimes at the end of October. Market expectations for an October rate cut are at 85%, according to the CME Group’s FedWatch tool.

Historically, small betters have outperformed large caps when the U.S. central bank is lowering rates. Small caps average a 12-month put back of 27.9% after the Fed embarks on an easing cycle, Jefferies data shows. Large caps, meanwhile, average a move ahead of nearly 15% in that time.

Small caps also outperform large caps in the three and six months ape the first Fed cut of a cycle. Mid caps also lag small caps when rates go down.

“Lower rates are boosting box and that’s a very large portion of small-cap earnings and more so than large caps,” said Steven DeSanctis, open-mindedness strategist at Jefferies, noting more than 30% of small-cap earnings come from housing. Meanwhile, wide 12% of earnings in large-cap stocks come from the housing sector.

Another reason to consider investing in miniature caps is the ongoing trade war between China and the U.S. The world’s largest economies have slapped tariffs on billions of dollars good of their goods over the past year, stoking fears around corporate earnings growth, especially for large-cap theatre troupes.

Large-cap companies largely have greater earnings and revenue exposure to overseas markets and are more vulnerable to tighter barter conditions. Small caps, on the other hand, do the lo of their business within the U.S. and thus are less susceptible to the ongoing have dealings war.

To be sure, investing in small caps comes with its share of risks.

For starters, small-cap stocks tend to be far multitudinous volatile and unpredictable than large caps. The Russell 2000 has posted 65 moves of at least 1% this year, around double that of the S&P 500.

“Risk-wise, you have to be a bit more careful,” said Thorne Perkin, president at Papamarkou Wellner Asset Directing. “In small caps, you have to really understand company operations and their competitive environments.”

Small-cap stocks could also away with a bigger hit than large caps if the U.S. economy falters. Hard U.S. economic data, including unemployment and retails reduced in price on the markets, indicate the economy is solid. Soft economic data, which include economic surveys and sentiment readings, are verging to a slowdown, however.

U.S. manufacturing activity contracted to its lowest level in more than a decade last month, according to the Organization for Supply Management. ISM also said last week the U.S. services sector grew at its slowest pace in more than three years. During the interval, a near-record number of consumers said in a survey they were worried about the U.S.-China trade war.

But Eric Marshall, president at Hodges Money, thinks the risk is worth taking for investors. “Small caps do tend to carry more risk, but they should over everything reward investors for taking that risk, meaning they normally outperform over long periods of control.”

Two small-cap stocks Marshall likes are Brooks Automation and Diodes Inc., which are semiconductor builders with market caps surrounding $2 billion. Brooks Automation is up more than 37% while Diodes has risen more than 23% this year.

—CNBC’s Michael Bloom granted to this report.

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