After the Perfect Storm in US Smaller-Cap Stocks by Bruce K. Aronow and James MacGregor, AllianceBernstein

Last year was a tough one for US small- and mid-cap stocks, but there’s reason to think 2015 may be different. For investors who trimmed their smaller-cap allocation last year, we think it may be time to consider taking it back to its long-term target.

Over time, a steady allocation to the asset class has paid off. But first, let’s take a brief look at what went wrong in 2014.

Valuation was a big part of the problem. Smaller-cap stocks—especially biotech and Internet names—began the year with fairly rich valuations both absolutely and relative to their large-cap counterparts. When reported earnings failed to measure up to initial expectations—in many instances because of the unusually harsh winter—investors soured on the entire asset class.  Earnings for their more diversified larger-cap peers held up much better.

Volatility also inflicted damage. A bout of market turbulence early in the fourth quarter, sparked by plunging oil prices and worries about the global economy, caused many investors to retreat from risk by paring back equity holdings in general and taking refuge in safe havens such as US Treasuries. Smaller-cap companies suffer disproportionally from declining risk appetites.

Put another way, 2014 served up something of a perfect storm for smaller-sized companies. The Russell 2500 Index of US small- and mid-cap (SMID-cap) stocks still provided a modest positive return in absolute terms, but it was well off the blistering pace set over the prior two years and well below what large-cap stocks delivered.

Smaller-Caps: Strong Historical Performers

Now let’s widen the lens. When we do, we find that over time, smaller-cap stocks have been stellar performers. As the Display below shows, US SMID-caps have comfortably outperformed not just US large-caps over the long run, but also international equities and intermediate maturity bonds.

Smaller-Cap Stocks

In our view, too, the backdrop for the asset class has brightened.  The strengthening US economy, which is expected to continue growing more swiftly than economies overseas, favors smaller, domestically-oriented firms because a larger percentage of their sales are US-based. That should benefit earnings growth at smaller-cap companies.

What’s more, small-caps look more reasonably valued today than they did at the start of 2014, when data from Russell Indexes showed the Russell 2000 was trading at a 20% premium to the large-cap Russell 1000 Index. By Dec. 31, that premium had been cut in half,  leaving it roughly in line with the long-term average.

It’s Time Invested that Matters, Not Timing the Market

As a result, we think investors who cut their smaller-cap allocation during last year’s turmoil might want to think about restoring it to its long-term target. As the following Display shows, missing just one month of the average small-cap bull market would have cut average annual total return by about 15%. Sitting out for five months would have more than halved it.

Smaller-Cap Stocks

SMID-Caps: Often Misunderstood, Mispriced

To be sure, smaller-cap stocks are more volatile than large-caps. One reason for that boils down to neglect. Smaller companies everywhere receive less research coverage than large ones. The average stock in the Russell 2000, for example, has fewer than seven analysts covering it, compared to 16 for the average Russell 1000 stock.

As we’ve seen, this neglect often causes smaller companies to be misunderstood and mispriced. But it also gives active managers more opportunity to add value, especially if they have the research resources needed to dig into company fundamentals.

In our view, investors should look beyond last year’s performance and consider maintaining a consistent allocation to smaller-cap stocks.  If 2015 turns out to be the year the US economy finally shifts into high gear, the ride’s likely to be a lot smoother.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.

Bruce K. Aronow is Team Leader and Portfolio Manager/Analyst of US Small/SMID Cap Growth Equities, and James MacGregor is Chief Investment Officer of US Small and Mid-Cap Value Equities, both at AllianceBernstein.