MW Investors worried about Trump can cut their risk by buying this 'forgotten' group of stocks

By Philip van Doorn

You can diversify away from the S&P 500 to reduce risk, based on stocks' prices to expected earnings and on expected earnings growth rates - at the same time

The decision by President Donald Trump to slap new or increased tariffs on important trading partners is not the type of news investors want to see. But long-term investors - especially those making regular contributions to retirement accounts - are likely to keep pouring money into the stock market. They might ask how they can reduce risk in a world of daily uncertainty.

Read: Stocks kick off March with biggest drop in months as Trump tariffs rattle market

"The biggest risk right now is concentration," according to Francis Gannon, co-chief investment officer at Royce Investment Partners in New York.

"The world is concentrated in the upper end of market cap. If you want to diversify, even from a risk perspective, you are a little better off in small-caps at this particular moment," he told MarketWatch Tuesday.

Gannon co-manages the $1.9 billion Royce Small Cap Fund PENNX, which was established in 1972. It was one of the first open-ended funds focused on the small-cap space. The fund is rated four stars (out of five) within Morningstar's "small blend" space.

The case for cutting risk through diversification with small-cap stocks

We can make a good case that small-cap stocks have been "forgotten," to use Gannon's term for investors' attitude about the space.

Small-caps' valuations to expected earnings are below or in line with long-term averages, while large-cap stocks appear to be expensive. And you are probably already aware of how concentrated the S&P 500 SPX is to the biggest names.

The "Magnificent Seven" group of companies - Apple Inc. $(AAPL)$, Microsoft Corp. $(MSFT)$, Nvidia Corp. $(NVDA)$, Amazon.com Inc. $(AMZN)$, Alphabet Inc. $(GOOGL)$, Meta Platforms Inc. $(META)$ and Tesla Inc. $(TSLA)$ - make up 30.6% of the SPDR S&P 500 ETF Trust SPY. The top 10 companies in the exchange-traded fund make up 35.7% of the portfolio.

The Royce Small Cap Fund is benchmarked to the Russell 2000 Index RUT, which includes the smallest 2,000 companies in the Russell 3000 Index RUA, which itself is designed to represent 98% of the U.S. market for publicly traded stocks.

For another illustration of how concentrated investors have been against small-caps, Gannon said that at the end of 2024, the Russell 2000 companies together represented only 4.7% of the Russell 3000 by market capitalization.

"You would have to go back to the 1980s to see such a small portion of the Russell 3000 being small-caps. The average is closer to 8%," Gannon said.

You can easily diversify by moving some money or changing the investment allocation of your regular retirement-account contributions to mutual funds or ETFs focused on small-caps. For an actively managed approach, The Royce Small Cap Fund has a portfolio of about 185 stocks that "reflects the idea of quality and value within the small-cap space," according to Gannon, who referenced the firm's "robust research process."

He said that Royce tends to hold stocks for three to five years and that "the portfolio tends to protect on the downside and to participate on the upside," as the broad stock market goes through cycles.

ETFs tracking small-cap benchmarks include the iShares Russell 2000 ETF IWM and the Vanguard Russell 2000 ETF VTWO.

For a more selective approach to small-caps, based on criteria including four consecutive quarters of profitability before initial inclusion, there are ETFs that track the S&P Small Cap 600 Index SML, including the Vanguard S&P Small-Cap 600 ETF VIOO and the SPDR Portfolio S&P 600 Small Cap ETF SPSM.

You can narrow your focus further within the S&P 600 Small Cap group with ETFs such as the Invesco S&P SmallCap Quality ETF XSHQ or the Invesco S&P SmallCap Momentum ETF XSMO.

The value case for small-caps

The stock valuation measure used most often by investors is the forward price-to-earnings ratio. This is a stock's share price divided by the consensus earnings-per-share among analysts polled by FactSet for the next 12 months. Here is how weighted forward price-to-earnings ratios compare for three broad S&P indexes, and how their current valuations measure up to longer-term averages:

   Sector or index      Forward P/E  Forward P/E to 5-year average  Forward P/E to 10-year average  Forward P/E to 15-year average 
   S&P 500                     21.3                           106%                            114%                            126% 
   S&P Mid Cap 400             15.3                            95%                             96%                            100% 
   S&P Small Cap 600           15.1                            96%                             96%                            100% 
                                                                                                                   Source: FactSet 

The large-cap S&P 500 stands out as appearing to be expensive when compared with the averages.

The table doesn't include the Russell 2000 - the performance benchmark for the Royce Small Cap Fund - because about 45% of companies in the Russell 2000 were unprofitable during 2024, according to Gannon. He said that the percentage of unprofitable small-caps was "one of the highest numbers we have seen in non-recessionary periods."

Despite including hundreds of unprofitable companies, the Russell 2000 is the standard small-cap benchmark among money managers because it was established in 1982, while the S&P Small Cap 600 Index was launched in 1994.

The growth case for small-caps

Here are projected compound annual growth rates (CAGR) for revenue and earnings for the three S&P indexes. These are based on weighted ratios of prices to consensus 12-month estimates for sales per share and earnings per share for the indexes. The estimates are adjusted by FactSet to match calendar years, for companies whose fiscal reporting periods don't match the calendar.

   Index               Two-year estimated sales CAGR through 2026  Two-year estimated sales EPS CAGR through 2026 
   S&P 500                                6.0%                                         13.4% 
   S&P Mid Cap 400                        4.6%                                         13.3% 
   S&P Small Cap 600                      4.1%                                         16.2% 
                                                                                                   Source: FactSet 

All the EPS growth projections are impressive, but the small-cap group is expected to increase profits most quickly. That makes for an intriguing combination with the group' slow P/E relative to that of the S&P 500.

Gannon said that for small-cap U.S. companies, "earnings seemed to bottom" in 2024. One reason the group's profit growth is expected to accelerate is a reduction in borrowing costs as the Federal Reserve has lowered short-term interest rates. "We have tried to focus on the next two years' earnings profile for small-caps being must better than the rest of the market," Gannon said.

More from the Deep Dive column:

-- 10 dividend stocks for investors who also want growth

-- Three AI stocks to buy if you want to look past the Nvidia hardware build-out

-Philip van Doorn

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March 04, 2025 12:20 ET (17:20 GMT)

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