Why do small caps often recover faster than blue chip stocks?

The global pandemic has shocked the world’s economies and financial markets.

With the situation evolving daily and no-one really sure how things will look six months or a year from now, some investors are trying to envisage what the ‘recovery’ might look like.

This post isn’t about predicting how much carnage is yet to play out on the financial markets — or when the recovery might come.

Rather, we’re going to take a look at a type of stock that, historically at least, has a record of bouncing back harder and faster than others.

These stocks are small caps — stocks with relatively small market capitalisations.

In Australia, that generally means a stock with a market cap of up to $400 million (whereas Australia’s large cap stocks make up the top 50 companies trading on the ASX, generally with market caps in the billions).

Rebound rockets: why small caps have tended to pop first when markets recover from a crash

According to Institutional Investor, small companies can begin to rebound faster than larger companies in growing economies.

The reason for this is easy to understand.

Imagine two aircraft, one a huge Airbus passenger jet and the other an F-16 fighter jet.

They take off at the same time.

The Airbus needs a long runway and gathers speed gradually before lifting off.

The F-16, on the other hand, rockets into the sky at breakneck speed.

Once in the air, the Airbus can’t manoeuvre nearly as well as the F-16, which can roll and dive blindingly fast.

(But, the Airbus — large cap stocks — can of course travel much further and give its passengers a much more comfortable ride. There’s no in-flight meal on a fighter plane.)

This analogy explains why small cap stocks can be first to produce gains in a recovering stock market.

A small cap company tends to be lean, efficient and geared toward aggressively pursuing opportunities, whereas an established blue-chip company may be carrying large amounts of debt and be more dependent on the wider economy.

In the five years after the GFC, the Russell 2000 Value Index (the US benchmark index for smaller stocks) outperformed the S&P500 by about 50%.

Of course, this doesn’t guarantee small caps will repeat this feat when the markets eventually do enter their next recovery or boom.

Small caps do tend to get hit harder in a down market

Going back to our aircraft analogy, the advantages small cap companies have in recovering markets have a flipside.

Small caps — with smaller market caps and less established business operations — tend to get hit harder when markets drop.

Where the F-16 is built to fly combat missions (like a small cap company competes with other companies for success and survival in markets), it is of course the less safe and stable aircraft.

The Airbus on the other hand can fly at high altitude for a very long distance.

And if we want to bring market sentiment into this already stretched analogy, which of these planes are most people likely to choose for a trip across hostile airspace?

The Airbus every time. Bigger, safer and less likely to go down.

Navarre is the Founder of Navexa — a portfolio analytics service made for Australian investors. Navarre left a lucrative corporate developer job to combine two of his passions; investing and entrepreneurship. He created Navexa because he couldn’t find a portfolio analytics service that met his own high standards. Now, he’s focused on helping as many Australians as possible get more from their portfolios through the smart and creative use of data. Follow Navarre on Twitter and connect with him on LinkedIn.