Small-Cap Stocks: A New Dawn?

While everyone has been fixated on the developing Artificial Intelligence narrative, sending technology large caps sky-high, a quiet transformation has been transpiring in recent months. As the outlook for an imminent recession has all but dissipated, beaten-down small caps have been showing signs of life while narrowing the performance gap versus the large caps.   

Economic Strength Ignites Risk-On Sentiment

After months of downbeat economic expectations, those bearish on the economy have seemingly thrown in the towel. It is certainly difficult to continue forecasting a recession in the face of multiple reports confirming that the economy is humming along, unfazed by the high interest rates. Last quarter’s GDP growth has just been confirmed at 3.4%; meanwhile the job market continues to show vigor and the consumers display resilience, reflected in strong retail sales.

Consumption – the main driver of economic growth – is propped up by stock market gains, creating a positive “snowball effect”. As of the end of 2023, household net wealth hit a new all-time high, so it is no wonder that individual investors are optimistic regarding the economic outlook and bullish on equities. At the same time, various recent surveys of asset allocators and money managers show that they see little chance of a recession ahead, with over 90% reporting they are net overweight in stocks. Even economists have thrown away time-tested recession indicators, such as an inverted yield curve and Conference Board’s leading economic indicators (LEI), which continue to flash red.

The short-term stock market moves are heavily influenced by Fedspeak and speculations on how this or that economic data point will affect the central bank’s policy. However, market participants seem to have gotten comfortable with interest rates staying higher for longer, as long as the reason for that is economic strength. This comfort has led both retail and professional investors to wade into riskier bets, such as high-yield bonds, Bitcoin, or previously struggling small caps.         

Recent Small-Cap Outperformance

For the better part of the past year, the stock market rally was driven by technology and communications large-caps, with the largest contributions coming from the Magnificent Seven megacaps. However, the improving economic sentiment this year has given way to a significant broadening of the rally, sweeping in different asset classes, sectors, and market cap segments.

Technology still rules, to be sure, and is expected to continue leading the markets, spurred on by the ongoing AI revolution. However, now may be a good time to diversify investment portfolios, as current market conditions present several opportunities outside of large-cap tech.

Large-cap tech stocks – as measured by the Technology Select Sector SPDR Fund (XLK) – have soared by 45% in the past 12 months, while the broad large-cap universe, represented by the SPDR S&P 500 ETF Trust (SPY), clocked in a gain of 32%. At the same time, small caps, mirrored by the iShares Russell 2000 Fund (IWM), registered a modest increase of 21%.

But over the past month, things have turned around, with the IWM outperforming both large-cap cohorts. Overall, all benchmark indexes have continued to gain, which means that IWM’s outperformance isn’t the sign of investors running away from overpriced large caps, but a healthy addition to the rally’s depth, which actually signifies optimism regarding its persistence.

Investors’ belief that the economy is set for a “soft landing” at worst, or “no landing” at all, has been a key factor in the broadening rally. Small caps are an economically sensitive bunch, performing best when the economy is rebounding or running at full speed. At the same time, they will be among the first to benefit from rate cuts, when they arrive. So, barring large negative surprises, small-cap stocks may be poised to gain a lot more than their large counterparts, both because of the resilience of the U.S. economy and potential monetary easing down the road.            

Beware of Indexes Bearing Junk

Despite last month’s surge, small-cap stocks continue to trade at the largest forward valuation discount versus the S&P 500 (SPX) in the past 20 years. To give context, this is partly because they underperformed for several years, as well as due to the fact that large-cap indexes’ valuations have been skewed by the tech behemoths’ rally. Clearly, there is a lot of value to be found in small caps, and it has started to entice a growing number of investors.

However, buying a small-cap ETF, which mimics the holdings of a corresponding index, may not be the best idea at the moment, at least while interest rates remain high. Despite the market’s apparent exuberance, in investing as opposed to day trading, fundamentals matter – and on average they are much weaker in the small-cap world.

Thus, companies in the small-cap index Russell 2000 are almost twice as indebted as SPX members, with the lion’s share of their debt set to mature in the next five years. To make matters worse, half of the small-cap companies’ debt is floating – which means that the interest it owes has risen with the Fed’s key rate increases. In contrast, for the S&P 500 this number hovers around 10%.

In addition to the debt load threatening these companies’ ability to continue afloat, there’s an inherent flaw in small caps as a group: a lack of profitability. About 40% of Russell 2000 stocks are unprofitable, versus 6% of the S&P 500 firms that have negative net earnings. Of course, “junk stocks” can at times – when the market is in a risk-loving mood – outperform even the most profitable champions, but these feats don’t usually last.    

A Case Study in Fundamental Appraisals

Instead of chasing after indexes, investors wishing to bet on a small-cap comeback are advised to choose individual companies, carefully reviewing the fundamentals to find better-quality stocks with lower leverage and positive earnings and cash flows.

The newest S&P 500 entrant, Super Micro Computer (SMCI), serves as a further testament to the importance of fundamentals. It used to be a small-cap stock until less than two years ago. However, for years it displayed solid financials and a strong balance sheet, which allowed it to come prepared to the AI party and rise to prominence.

Just like SMCI, there may be many more potential outperformers among the small-cap firms, hiding among a myriad of loss-making, overleveraged losers. Finding these gems is not an easy task, but it is more than doable using TipRanks tools, such as the customizable Stock Screener, which allows for filtering for high-quality, analyst-approved stocks of any size and sector, taking into account their earnings trends, valuations, and more.

Potential Small-Cap Winners

Great small caps can be found in any sector, allowing for diversification for various scenarios. For example, a brightening economic outlook may lead to a rebound in energy, benefiting firms like DHT Holdings (DHT), an independent crude oil tanker company. At the same time, the reshoring and “Made in America” movement could gain even more momentum. This would  advantage industrial companies like Powell Industries (POWL) and contractor services firms like Limbach Holdings (LMB).

Improving economic outlook will also lead to higher demand for lending, propping up the shares of specialty finance companies like Sixth Street Specialty Lending (TSLX). The housing market is already rebounding, with real estate development firms like Forestar Group (FOR) poised to see their revenues rise. The resilience of the American consumer is expected to continue supporting retailers and wholesalers like Caleres, Inc. (CAL), as well as home improvement firms such as American Woodmark (AMWD).

Technology and Communications sectors also include several promising small caps, differentiated by their solid finances (not typical in the small-cap growth universe, but more frequent than one might expect). Thus, there is Opera (OPRA), which offers an acceleratingly popular browser and has been showing triple-digit earnings growth over the past several quarters. A provider of mobility Software-as-a-Service Karooooo (KARO) seems to be a good value, given its strong earnings trend.

A Nasdaq-traded strategic & digital transformation consultancy Hackett Group (HCKT) seems to be as efficient in riding the AI wave as its large-cap peers while carrying a much lower valuation. A global payment and commerce-enabling platform Payoneer (PAYO) is loved by Wall Street analysts, who foresee as much as 40% upside for the stock in the next 12 months. A better economy ahead would also mean more demand for money transfer services from companies like International Money Express (IMXI).

These are just a few examples of small-cap companies, found using the TipRanks’ stock screener tool, whose solid fundamentals make them less vulnerable to high interest rates. Perhaps most importantly, their robust business models support their earnings prospects and enable them to capitalize on the U.S. economy’s strength.