BofA Securities Favors SMID-Cap Value Stocks Citing Attractive Valuations

Bank of America Securities is advocating for an overweight position in small- and mid-cap (SMID) value stocks, citing a combination of attractive valuations, an anticipated earnings recovery, and historical performance trends. The firm's equity and quant strategists noted that value stocks are better positioned to lead in the current market environment.

Valuation Discrepancy

According to BofA, value stocks present a more compelling entry point based on valuation metrics. The report highlights that growth is historically expensive compared to value across most of the firm's tracked metrics for both small and mid-caps.

• The Russell 2000 Value index is the only size/style benchmark currently trading below its long-term average forward price-to-earnings (P/E) ratio, at 12.5 times versus its 13.3 times average.
• Mid-cap value stocks are trading at 15.1 times forward earnings, which is 10% above their historical average but still considered the least stretched among other indexes.
• In August, forward P/E ratios for the broader market compressed as positive earnings revisions outpaced stock price gains, bringing the Russell 2000's P/E down to 15.3 times, in line with its historic average.

Catalysts for a Value-Led Market

BofA strategists outlined several key reasons for their preference for value, arguing that the style typically outperforms during specific economic regimes. They believe value stocks are poised to benefit from an expected earnings-per-share recovery in the second half of the year, a period when value has historically led the market.

Ad

Other drivers include value's tendency to outperform during mid-cycle economic phases and interest rate hiking cycles. The firm also pointed to lower concentration risk in value indexes, which could be an advantage if market leadership broadens. Furthermore, BofA noted that value currently exhibits higher quality characteristics than growth, a factor expected to be rewarded in the coming months.

Economic Headwinds and Risks

While constructive on SMID caps versus mega caps, BofA acknowledged potential risks, primarily from monetary policy. The bank's economists anticipate three Federal Reserve rate hikes this year, which could create headwinds for smaller companies.

A prolonged hiking cycle poses a significant risk for small caps due to their higher leverage and refinancing needs. Higher interest rates also threaten the ongoing manufacturing recovery, as the ISM manufacturing index is negatively correlated with rate changes. According to BofA, the Russell 2000's current valuation is already pricing in a deterioration of the ISM index from 55 to 52. Consequently, the firm sees more upside within the SMID space for mid-caps, which they believe carry less risk from Fed rate hikes compared to their small-cap counterparts.