Forget Big Recession-proof Stocks in Favor of Recession-slashed Small Ones

Microsoft MSFT was supposed to be the recession-proof company that would perform in an environment in which investors can no longer broadly bet on the market. Just a couple of days ago, I thought it hit a low—and maybe it did. But on Thursday, this struggling stock also revealed something that surprised me: That the company, not just the stock, sees a less than optimal fourth quarter ahead.

The company now expects to report between $51.94 billion and $52.74 billion in revenue for the quarter as compared to a previous fourth-quarter revenue forecast in the range of $52.4 billion to $53.2 billion. Earnings forecasts were also adjusted downward, though minimally.

Yes, Microsoft is a solid long-term bet at these prices – as are Amazon AMZN, Meta "Facebook" FB, and a host of others (particularly FB, the trade of the day on Sandberg's departure), but if investors are now forced to become selective stock pickers scouring the market for big upsides in a down market, it is time to look at the devastated small-cap sector for big potential wins.

Not Recession-proof, But Recession Priced-in

If investors are flying not to quality but to quantitatively undervalued stocks, the struggling small-cap sector is where to look. A broad look shows that, while the S&P 500 has fallen over 14% on recession-related woes, there will still be far further to fall. To wit, the current forward (P/E) ratio on the S&P 500 sits at 17.9X, down from where it was but still above its two-decade median of 16X. Basically, we are still looking at overvalued equities on the index from a historical perspective.

On the other hand, the S&P 600, a broad index tracking "small-caps that meet specific liquidity and stability requirements," sits at a P/E ratio of 11.7X. This is especially pertinent when considering that historically the S&P 600 has traded at a 7% premium to the S&P 500.

The point here is that there may be more value in small-caps than we have seen in quite some time. And since investors can no longer just count on betting on big companies to fill their pockets in a big way, the turn towards small-caps will be the retail investment story of the 2022 and possible 2023.

Big Small-cap Indexes With Huge Potential

If you are looking for broad exposure to small-caps and don't feel like selectivity has been your friend (I am starting to feel this way myself), a couple of good growth stock index funds are the Vanguard Small-Cap Growth (VBK) or active funds like Alger Small Cap Focus (AOFAX).

When it comes to real declines and real upsides, take a look at the Russell 2000 Index, which has fallen by 24% from its November record. Moreover, Russell 2000 traded at 12.5X its projected earnings at the end of April over the next 12 months, below the average of 15X times since the mid-80s, according to Bank of America. This means that, in terms of valuation, this standard small-cap benchmark is trading at the largest relative discount since 2001 to its large-cap cousin, the Russell 1000, since 2001.

While in this market, it's better to choose selectively. When it comes to small-caps, the investor willing to allocate a bit more to the small-cap sector— even through a broad index—might just as well see the big gains so many of us expected from the broader market this year and beyond.