Small-cap stocks were hit harder than large-caps in the coronavirus sell-off. But given the extreme market dislocations, select smaller companies with innovative advantages could offer investors a surprising source of diversification for the uncertain times ahead.

Investors in small-cap stocks have had a particularly rough ride since the pandemic began. Even after recovering from a late-March trough, the Russell 2000 Index of US small-cap stocks was down 24% since the beginning of the year through May 15, while the Russell 1000 Index of US large-cap stocks has fallen by 11%. When investors panic, they shun smaller stocks, which are widely perceived as riskier than are larger peers.

Are Smaller Stocks Really Riskier?

But is the perception accurate? Not necessarily. Smaller companies are considered riskier because they are believed to have less funding access, financial stability and managerial depth than are larger firms. They’re often seen as less diversified, which can make revenues vulnerable in a downturn. And about 25% of Russell 2000 companies aren’t profitable, versus 6% of Russell 1000 companies (Display, left).

Yet many smaller companies don’t fit the stereotype. In fact, US small-caps have lower debt levels than US large-caps (Display above, right). Smaller companies often have access to venture capital and convertible debt funding—even in a crunch. In many cases, smaller companies are unprofitable by choice because they’re investing in research and development (R&D) to fuel future growth. For example, early-stage biotech companies make up 13% of the Russell 2000 and account for most of the unprofitable companies in the benchmark; many have no revenues or earnings because they’re focused exclusively on developing new therapeutics for future growth.

These characteristics have prevailed in market recoveries. While small-caps are often hit harder in downturns, such as the dot-com bubble or the global financial crisis, they tend to outperform large-caps in a rebound (Display). It’s too soon to say what will happen in the coronavirus recovery. Still, small-caps outperformed large-caps slightly in April as US markets bounced back from the trough.

Even before the current crisis, investors weren’t enthused by small-caps. In fact, the Russell 2000 has trailed the Russell 1000 for the past five years. The continued underperformance is creating opportunities in smaller stocks that have been unjustifiably punished in the recent downturn.

Innovation Can Make the Difference

Companies with an innovative edge deserve particular attention. Their advantages may be overlooked because smaller companies often are not understood by the market. Most aren’t household names, and small-caps typically get much less analyst coverage than do larger-cap peers. So it’s easy to miss a minnow that’s poised to take market share from large incumbents that are slow to react to new competition.