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Small caps ‘have an edge’ over large caps in 2022: Strategist

With markets still concerned with inflation and how the Fed may react in regard to rate hikes, investors are gearing up for an uncertain 2022.

And according to Francis Gannon, co-chief investment officer at Royce Investment Partners, small caps may be the place to weather these uncertainties in the new year.

“I think part of the opportunity here with small caps is the fact that they haven't done as well as some of the other asset classes,” Gannon said on Yahoo Finance Live (video above). “Small caps today are about 8% below their most recent high and yet, fundamentals for many of the businesses continue to improve.”

According to Gannon, the industries that performed the best within the small cap space in Q4 2021 were industrials, financials, and information technology.

“I think those are the areas that represent great opportunity in a world where people are concerned about inflation, wage pressure, et cetera,” he said. “These are areas that I think represent good opportunity within the small cap space.”

Traders work on the floor of the New York Stock Exchange (NYSE) on the first day of trading in the new year on January 03, 2022 in New York City. (Photo by Spencer Platt/Getty Images)
Traders work on the floor of the New York Stock Exchange (NYSE) on the first day of trading in the new year on January 03, 2022 in New York City. (Photo by Spencer Platt/Getty Images)

Another edge that small caps have is the broadening participation in growth small cap companies are demonstrating within the indices relative to their larger-cap peers, he said, adding that small caps this year “are the economy” for the U.S.

“In fact, if you looked at the equal-weighted [index] — so [the equal-weighted] Russell 2000's performance last year versus the cap-weighted, you would have seen it have done actually much better than the overall index,” he added.

In contrast, Gannon noted that the opposite is happening in the large cap space, where cap-weighted indices are underperforming their equal-weighted counterparts.

Small cap headwinds

On top of concerns surrounding inflation and the Fed’s ongoing tapering, Gannon said the threat of higher volatility in 2022 and historical performances are what pose the most significant risks to strong returns in the small cap space.

“I think one of the things that people aren't thinking about is in the small cap space, we've had three double-digit return years in a row — something that we've only seen twice before in the history of the Russell 2000,” he said. “The last time we saw it was back in the mid-90s, '95 through '97. And we tend not to see that fourth year of double-digit returns.”

A trader works as a screen displays President Biden delivering an update on the Omicron variant, on the floor of the New York Stock Exchange (NYSE) November 29, 2021. REUTERS/Brendan McDermid
A trader works as a screen displays President Biden delivering an update on the Omicron variant, on the floor of the New York Stock Exchange (NYSE) November 29, 2021. REUTERS/Brendan McDermid

Ultimately, though, Gannon is expecting “muted returns” in the market compared to 2021 — echoing other experts’ opinions that the theme for 2022 will be a “growing but slowing” economy — with small caps edging out their large-cap peers due to strong, broader earnings growth.

And while the Omicron variant surge also poses a potential risk, Gannon still believes small cap equities to be undervalued.

“The effects of inflation — we're going to have volatility around [the] taper,” he said. “But in the same token, small caps are cheap on a relative basis, and that's the opportunity here.”

Thomas Hum is a writer at Yahoo Finance. Follow him on Twitter @thomashumTV

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