In a very interesting article that appeared recently on Advisor Perspectives, Michael Weiss and Yuliya Tarasava examine the tendency of small capitalization stocks to outperform larger companies in the period when the economy is emerging from recession. While the article focuses on broad asset allocation questions rather than individual stock picking, the topic has relevance for value investors because it suggests that small cap stocks deserve more careful attention during recessionary periods.
Smaller companies tend to be less closely scrutinized by analysts simply because the market for investment research demands more coverage of larger companies with more liquidity. There are thousands of small and micro-cap companies that receive hardly any Wall Street coverage which inherently creates opportunities for enterprising investors. Additionally, many small companies are much more sensitive to recessions because they are more exposed to lack of financing when liquidity dries up. However, within the small cap universe, many companies with large net cash balances are nevertheless punished during recessions as if they are on the verge of collapse.
Here is a brief excerpt from the article explaining the basic rationale for the outperformance of smaller stocks coming out of a recession:
We would argue that many fundamental factors support a case for small- and mid-cap stock outperformance coming out of a downturn. First, in order to adjust to an environment moving from contraction to expansion, a company needs to be nimble. To that end, small- and midsized companies are generally better able to quickly add to their work forces and ramp up production in anticipation of an improvement in the economy. According to Giuseppe Moscarini, an economist at Yale University and Fabien Postel-Vinay of the University of Bristol, employment growth at small firms is faster than at larger companies early in the recovery period because small firms are able to capitalize on the slack labor market typically associated with this point in the business cycle. As a result, small- and mid-sized firms are better able to take advantage of the environment and produce stronger gains in both revenue and earnings. Second, small caps generally experience steeper declines early in a recession due to a flight to safety that naturally occurs, resulting in oversold conditions and under-valued small- and mid-cap stocks. Third, smaller companies tend to get a performance boost when mergers and acquisitions activity increases, which is common toward the end of a recession when valuations become more attractive and larger companies look for ways to grow their businesses.
The authors clearly are focusing on broader asset allocation questions and equate risk with volatility which makes little sense to value investors who understand that real risk is the prospect of permanent loss of capital. However, to the extent that the study leads value investors to pay special attention to small caps during recessions, it seems likely that the phenomenon can be exploited in the future.