Falling Selic tends to favor small companies on the Stock Exchange; understand – 05/30/2023 – From Grain to Grain

It is increasingly clear that a downward cycle in the Selic rate should start in the second half of 2023. Therefore, investors should begin to assess in their portfolio which positions tend to benefit most from this downward movement in interest rates. In past articles, I have already explained what to do with the fixed income installment. Today I’m going to address an aspect that the most aggressive investors who own stocks should pay attention to.

I’ll explain how an investor should position themselves between small-cap and large-cap stocks given falling interest rates.

In this month of May (until the 29th), the index formed by small capitalization companies and calculated by B3 (SMLL) appreciated by 13.96%. In the same period, the Ibovespa (BOVA) rose 5.7%.

Until the end of last month, the difference between the return of the last 12 months of SMLL and BOVA was -19%. That is, those who preferred to invest in SMLL instead of BOVA had worse performance. And it wasn’t little.

However, this month of May, the shares of smaller companies had an excess return on the general market of more than 8%.

This month could mark the beginning of a trend change.

I’m not saying that this is the time to buy stocks, but that the performance of smaller companies can successively outperform large companies when evaluated over 12-month horizons.

Graphic

The chart above shows the relative performance of these two indices over 12-month periods. The blue line represents the difference between the 12-month return of the two indices. When the graph rises above the zero axis, it means that the SMLL is performing better than the BOVA in 12 months.

The orange line indicates the average difference in profitability between the two indices. Note that this average in the long term is almost zero, that is, in the long term it would not make much difference to be in one or the other. However, there are times when each of the two indexes tends to do better.

Note that the CDI scale on the right is inverted. Therefore, the rising CDI graph means falling interest rates. Notice in the graph that the return of the SMLL in relation to the BOVA is greater in these moments of falling interest rates.

Therefore, one of the factors that relatively favors the SMLL index is the cycle of falling interest rates.

Small companies are usually more dependent on credit to finance their investments, as they have less cash generation. As a result, they tend to be more indebted. Therefore, the drop in interest rates is an important reducer of financial costs and, therefore, leverages profit growth.

In addition, smaller companies tend to have a large part of their value attributed in the long term, as this is when their cash flows increase. In this way, the fall in interest rates favors the valuation them than mature companies that have most of their value in the short term.

Therefore, considering the prospect of a drop in the Selic and CDI rates from the second half of the year onwards, there is a tendency for small-cap stocks to outperform stocks in large companies.

Michael Viriato is an investment advisor and founding partner of Investor House.

Talk directly to me via email.

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