Fed Tapering Places Focus on Small-Cap Stocks

By Richard Cox
Richard Cox
Richard Cox
July 19, 2014 Updated: April 23, 2016

Earlier this year, the US Federal Reserve reduced its monthly asset purchases, and cut the total buying of Treasuries and mortgage-backed securities in quantitative easing programs to $65 billion. This was the central bank’s second decision to “taper” its stimulus programs and this sent a clear signal to investors and the markets as a whole. Essentially, the Fed has now shown its long-term intentions and is prepared to start allowing the economy to walk “on its own two feet,” without the added support of sustained monetary injections by the US central bank.

For investors, this should light some warning signals, as this really means we will start seeing more and more companies start to disappoint in their quarterly earnings releases. It should also be remembered that the most closely-watched (and most commonly bought) stock benchmarks have consistently posted record highs in recent months. This means that we are currently vulnerable to downside corrections that that it makes sense to start looking an alternative investment options in order to protect against negative surprises.

Comparative Performances

But given the broader trends we saw for most of last year, any significant economic declines are less likely to negatively impact small-cap stocks. The best evidence for this assertion can be seen in the fact that small-cap stocks had much better performances than their blue chip counterparts into the end of last year. Specifically, the Russell 2000 (the best gauge of small cap performances) generated gains of more than 38% when dividend payouts are added to returns in the underlying stock price. The Dow Jones Industrials did not even crack the 30% mark for the same period, and the S&P 500 did not fare much better, coming in just above 32%. This suggests that small-cap stocks are much better positioned to find protection in the event that we start to see the beginnings of a bear market at the currently elevated levels.

Potential Dividend Choices

Additionally, our current monetary policy environment can be characterized as a period of historically low interest rates — and this favors stocks that carry high dividend payouts. Of course, not all dividend yield is created equal, so it is important to base exposure to high-yielding stocks not only on the size of the payout but on the underlying fundamentals of the company as well. Investors need to see stable payout ratios and dividend yields that are sustainable in order to create a favorable viewpoint. One example that falls into this category can be seen in business development company Prospect Capital (NASDAQ:PSEC), which carries an 11.9% dividend yield and has seen substantial growth rates over the last three years.

Earlier this month, the company released its quarterly earnings report for Q4 2013, which showed that net investment income (NII) came in at $92.2 million, equal to $0.32 per share. With borrowing costs in the region of 5% to 6.25% (fixed corporate bonds), Prospect has some advantages over many of its counterparts that support its locked-in dividends for the majority of this year. The company’s latest conference call showed that Prospect’s loans carry a 90% floating rate, and this essentially suggests that these loans will increase once interest rate policy actually starts to change.

Potential Growth Choices

For those focused on growth rather than yield, a key small-cap example can be found in gas and oil explorer Matador Resources (NYSE: MTDR). Looking at attached chart (created by OT Trend ), we can see that the stock has tripled over the last year alone, driven largely by the stronger potential outlook for increased productivity at its Eagle Ford shale site. Earnings figures for last year came in at the higher end of guidance and its stable debt levels suggest that recent activity in the underlying stock price is much less likely to immediate surprises in balance sheet activity as we head into the next round of earnings figures. Chart activity shows that markets are now trading at the lower end of their shorter term ranges, with valuations currently 19% below the highs seen in December 2013.

In any case, it makes sense to start looking to small-cap alternatives to the more traditional investment choices, given the way policy stances at the Federal Reserve have unfolded over recent quarters. It makes sense to look at the various category choices that are available, as some investors will want to focus on stocks that have a preferable dividend yield while others will see growth stocks as more suitable for specific investment situations.

Richard Cox
Richard Cox