A Small-Cap Comeback? Bet on It
It only makes sense that the environment for the 'have nots' should start to improve versus their larger brethren this year — and there's a smart and prudent way to play it.
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My regular readers may recall that I have talked over the years about the "haves" and "have nots." This not only applies to society but also to businesses.
I can cite many examples of this, such as the Home Depots HD and Whole Foods of the world that were allowed to stay open during the Covid lockdowns while the local hardware place and grocery store were closed.
This has also applied to the divergence of earnings. Stripping out the seven largest tech companies by market capitalization across the S&P 500 leads to profit declines for the S&P 493 for each of the last two quarters. Overall, corporate profits fell 2.7% on a quarter-over-quarter basis in Q1.
Then we have stock market performance where AI juggernaut Nvidia NVDA has accounted for roughly a third of overall market gains in 2024 to date and has a market cap the size of the U.K. GDP.
While the Nasdaq and S&P 500 have powered higher in the mid-teens during the first half of the year, the Russell 2000 is almost exactly flat so far in 2024. In fact, the small-cap index is trading right where it was to start 2021. At some point, the large-caps that have led this very narrow advance in the market have to pull back and/or the small-cap sector needs to have a prolonged period of catching up.
There are several reasons I believe the environment for smaller companies should start to improve versus their larger brethren. First, small companies are more impacted by inflation as they have less control of their supply chains and get lower volume discounts. These names should start to benefit as inflation continues to fall.
Small-caps also generally have lower credit ratings and pay higher interest rates on their debt. They should be beneficiaries as the Fed finally starts to cut rates in the quarters ahead. One could even argue that the likes of Apple AAPL, Microsoft MSFT, etc. benefit from higher rates as that pumps the returns of the massive cash hoards on their balance sheets.
Finally, complying with regulations is a bigger burden for many smaller enterprises as they don’t possess the huge compliance departments, operations in different countries or have multiple lobbyists on the payroll to help reduce those costs across the business. The potential for a new administration along with a reduced regulatory burden might be a bit of a tailwind going into the election.
An easy way to play a potential rebound in, the small-cap sector is via the iShares Russell 2000 ETF IWM which provides broad diversification across the space. Indeed, by using covered call trades, I have managed to deliver decent returns over the years via this strategy even as the Russell 2000 has gone nowhere over that time.
Option Strategy
Here is how one can establish a position in IWM using a covered call strategy. Remember, covered call orders involve buying an equity and simultaneously selling just-out-of-the-money call strikes against the new position.
Selecting the January $200 call strikes, fashion a covered call order with a net debit in the $187.25 to $187.40 a share range (net stock price - option premium).
This strategy delivers downside protection of just under 7% across the trade expiration on a low-beta trade. The strategy also provides upside potential of 7% over the roughly six-and a-month option duration even if the stock trades down slightly— not very adventurous but prudent in this overbought market.
At the time of publication, Jensen was long IWM.
