Small Caps Shrug off Higher Interest Rates

Small-cap stocks "...tend not to perform well in a rising-rate environment."

These were Tim Hayes' comments in the Wall Street Journal earlier this year. Hayes is chief investment strategist at Ned Davis Research, and was discussing the outperformance of small cap stocks over the last decade.

He explained how rising interest rates usually hurt small-caps more than large-caps because when interest rates go up, so does the cost of borrowing. With less cash on hand, smaller companies typically don't have the same financing flexibility that larger companies do.

Since this financing is often critical in driving growth, small caps are at a disadvantage to larger companies.

But we're not in a rising interest rate environment right now. So even though rates are going to have to rise at some point, I'm recommending that investors increase holdings in small cap stocks.

In a low interest-rate environment, like the one we're in now, smaller companies do have access to growth-enabling capital. They can generate superior returns on that capital since they typically grow faster.

Think about the herculean amount of effort, luck and growth it would take for a company like Wal-Mart (NYSE: WMT) to double in size. They'd need to either double their locations or sell twice as many goods at each location.

But small cap companies are often just one tiny development away from doubling – or even quintupling – their size.

***The return on smaller market cap stocks this year indicates that investors are catching on.

So far this year, the S&P 500 index is up 5.9 percent, while the S&P 400 mid-cap index and S&P 600 small cap index are up 15.2 percent and 13.1 percent, respectively.

Clearly mid and small cap stocks are outperforming. The question now is – will these smaller companies continue to outperform?

It's possible that the answer depends largely on where interest rates are headed over the next few quarters. Rising interest rates could be one of the biggest obstacles for small-cap stocks, but there are a couple of reasons I think these stocks will continue to outperform.

First, many have tons of cash on hand so they are in good shape to handle higher financing costs. Second, I don't see rates moving higher anytime soon.

***In its second round of quantitative easing, the Fed has announced a $600 billion purchase program that is aimed at reducing long-term borrowing costs for businesses and consumers.

However, rates have actually gone in the exact opposite direction over the last two months. Take a look at the yield chart for the 10-year and 30-year Treasury bonds.

Notice that even though rates recently rose, stocks did as well.

“I think the bulk of the move is a position unwind exacerbated by the timing of the year”, said David Ader, head of the government-bond strategy at CRT Capital. This short-term selloff in Treasuries is likely the result of quick profit-taking - rather than a fundamental adjustment in inflation and growth expectations.

Even the quick burst higher in interest rates didn't hurt small cap stocks. This indicates to me that investors believe rates will go back down - and that small caps will continue to be a good place to seek investment returns.

Stuart Thompson, who oversees around $113.5 billion at Ignis Asset Management in Scotland, also believes the run-up in yields is over. He states, “The correction is almost complete and yields will go lower”.

Steven Major, head of fixed-income research at HSBC Bank in London, thinks that high employment and continued deleveraging by U.S. banks and consumers “justify lower yields”.

Both Thomson and Major expect the yield on the 10-year to drop to 2 percent by the end of 2011. And if growth remains sluggish, as many expect in coming quarters, rates will most likely remain at these all-time lows.

I expect rates to move lower and remain there for quite some time, and I believe the low rate environment will continue to help small-cap stocks.

Stay the course and increase exposure to small, high growth companies and I believe you'll be sitting on healthy returns in 2011.

For more on why small cap stocks tend to outperform over the long-term, click here.