Small cap stocks have enjoyed a huge bull run along with the rest of the market. A new report from Bank of America Merrill Lynch calls for small cap investors to focus on quality small caps. Specifically, that means small cap stocks that actually earn money.

It is often important for investors to differentiate between classes and market capitalization groups, as well as sectors. Merrill Lynch’s small cap research team sees the lower quality stocks lagging with more lagging performance to come.

A concern brought up is that many of the drivers for small caps have reversed course and are now lagging. The stock sectors that are expected to have losses in earnings over the next 12 months were down by about 2% in October, versus a gain of about 3% for those that analysts expect will make money.

The team said:

After a solid run by lower-quality stocks that coincided with the big move by the Russell 2000, we have started to see a reversal in performance. Some of the reversal is due to weaker performance by the size segment but we also think that valuations are not attractive … we think with small starting to lag large, lower cap and lower quality will also lag behind and this will continue into year-end.

Another driving force could be credit spreads and quality under tapering. The team is concerned that if credit spreads start to widen due to Federal Reserve tapering, then companies earning money should outperform companies losing money.

The three money-losing small cap sectors identified in the report are health care (biotech and pharma), followed by technology and then by consumer discretionary companies. They also showed that without health care, the nonearners are still lagging in performance and valuations are not attractive.

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