Wells Fargo says it's time to bet on riskier small caps over the consensus mega cap trade

Published Thu, May 28 202010:27 AM EDT

(This story is only for CNBC Pro subscribers ) After a springtime rebound trade dominated by mega-cap growth names, Wells Fargo now says it's time to take a second look at small-cap stocks, which have been hit hard from the pandemic shutdowns in the U.S. Equity strategist Christopher Harvey said in a note published Wednesday that he upgraded small-cap stock to an overweight rating given their multiyear underperformance, the favorable credit market outlook and a more optimistic macroeconomic outlook as more business reopen. The Wells Fargo team highlighted a number of smaller names, including footwear company Skechers , they believe will outperform the broader market over the next 12 months. That's likely to come as investors drift away from much-loved stay-at-home consumer tech giants like Amazon and Netflix that have led the S & P 500's climb since late March. "We believe firms that were first to fall into the recession will be among the first ones out helped by the 're-opening' of America," Harvey wrote. He added that unprecedented actions take by the Federal Reserve to support small business lending will also provide the hard-hit small-cap stocks with a meaningful backstop from which to stage a comeback in the second half of 2020. "In early April, we went 'all-in' on the Value style due to: (1) historic price dislocations; and (2) the Fed's fallen-angel debt buyback program (which has not yet gone live)," he added. "We are now taking the next natural step: upgrading small caps to overweight vs. large-caps." Harvey said that Wells Fargo Securities now sees double-digit outperformance over the next six to 18 months as the Fed's extended lending capabilities come online and offer liquidity to businesses that had seen either a dramatic fall in sales or been forced to close amid the coronavirus outbreak. The central bank created or expanded nine lending programs, committing $2.3 trillion, with the promise of more stimulus if needed. Congress, meanwhile, has appropriated $2.9 trillion to support households, businesses and state and local governments. But the newfound faith in small-cap names at Wells Fargo is noteworthy when one considers how poorly those names performed during first half of 2020 amid fears of a U.S. recession. Even compared to the broader stock market, which fell some 30% from its highs, small caps underperformed. The Russell 2000, which tracks the trading of some 2,000 U.S. small-cap stocks, plunged more 40% at its lows in March from highs earlier in the year. That underperformance versus the S & P 500 is likely thanks in part to the fact that about one-third of Russell 2000 components are unprofitable, making them more vulnerable if the economy faces an elongated slowdown. Smaller stocks also tend to be domestically-focused and more vulnerable to changes in the U.S. economy. That's why a sharp comeback in small-cap stocks over the last month, what investors have touted as a leading indicator, has investors hopeful that the rebound in the U.S. equity market may prove resilient. Despite its March swoon, the Russell 2000 is now outperforming the other U.S. market indexes, up 10.3% since April versus the Dow's 4.4% gain and the S & P 500's 4.1% climb. But with Wells Fargo and Harvey's team expecting that trend to continue, they're now looking at select small-cap names to offer savvy investors upside over the next one and a half years. The strategist said stocks including Skechers , Nomad Foods and Western Alliance should are all expected to outperform and all have a price-to-book ratio (a means of determining how "expensive" a security is) of less than 3. Harvey also highlighted energy names including Marathon Oil , Parsely Energy and Devon Energy as other small-cap stocks rated overweight that Wells Fargo thinks could see meaningful outperformance over the next year. Certain small-cap exchange-traded funds such as the iShares Russell 2000 ETF , which tracks the index, could also prove an easy option for traders looking for small-cap exposure. Others, such as the Vanguard Small Cap Value ETF or the iShares Russell 2000 Value ETF, distill the index further to include only those names that are below certain expensiveness thresholds for potential bargain plays. The iShares Russell 2000 ETF is up 11% over the last month while the Vanguard Small Cap Value and iShares Russell 2000 Value ETFs are up about 10% each over the same period.

Pedestrians pass in front of a Skechers store in New York.

Scott Mlyn | CNBC

(This story is only for CNBC Pro subscribers)

After a springtime rebound trade dominated by mega-cap growth names, Wells Fargo now says it's time to take a second look at small-cap stocks, which have been hit hard from the pandemic shutdowns in the U.S.

Equity strategist Christopher Harvey said in a note published Wednesday that he upgraded small-cap stock to an overweight rating given their multiyear underperformance, the favorable credit market outlook and a more optimistic macroeconomic outlook as more business reopen.

The Wells Fargo team highlighted a number of smaller names, including footwear company Skechers, they believe will outperform the broader market over the next 12 months. That's likely to come as investors drift away from much-loved stay-at-home consumer tech giants like Amazon and Netflix that have led the S&P 500's climb since late March.