BofA cites five reasons for favoring SMID value

BofA Securities is tilting toward value rather than growth in small- and mid-cap equities, backed by five arguments, among them a projected rebound in second-half earnings and lower valuations.

According to BofA equity and quant strategists, the Russell 2000 Value is the only size/style index still trading below its long-term average forward price-to-earnings ratio, at 12.5 times versus a 13.3 times average, despite being the top-performing size/style index year to date.

Mid Cap Value looks the least extended among the remaining indexes, at 15.1 times, or 10% above its average.

In small caps, growth is historically expensive relative to value on four of the six metrics BofA monitors and in line on the other two; in mid caps, it is expensive on five of six and in line on the sixth.

BofA’s five reasons for preferring value over growth in SMID stocks include an expected second-half earnings-per-share recovery, since value often leads during profit recoveries; value’s outperformance in mid-cycle environments and during hiking cycles; and reduced concentration risk, which would benefit if market leadership broadens.

The broker also highlights value’s higher quality relative to growth, with quality expected to lead in the second half. Value is additionally BofA’s favored area among large caps.

The top-ranked sectors in BofA’s latest small- and mid-cap quantitative rankings—including real estate and financials in both size categories, and energy in mid-caps—also carry larger weights in the value benchmark than in growth.

Separately, BofA said forward price-to-earnings ratios compressed across small, mid- and large-cap stocks in August 'for good reasons,' as positive earnings revisions outpaced price returns. The Russell 2000’s forward P/E declined to 15.3 times from 15.7 times, now about matching its historical average of 15.2 times.

BofA economists have increased their conviction to three rate hikes this year after Federal Reserve official Kevin Warsh’s Jackson Hole speech and a hawkish employment report.

A sustained hiking cycle would be a major risk for small caps because of their leverage and refinancing needs, while higher rates could also threaten the manufacturing recovery, as the ISM manufacturing index has a negative correlation with rate changes on a 15-month lag.

The Russell 2000’s current P/E implies further deterioration in the ISM to 52, from the present level of 55.

BofA said it remains constructive on SMID caps versus mega caps, citing a stronger expected second-half earnings recovery, less-stretched multiples and lower concentration. Within SMID, however, it sees more upside in mid caps, which have trailed small caps year to date but face less risk from Fed rate hikes.