Small-cap stocks have struggled this year, but things are looking up for the little guys.
One tailwind is upward earnings revisions, according to RBC Capital Markets.
“Small-caps are now participating in the recovery in earnings sentiment that began in August,” said Lori Calvasina, head of U.S. equity strategy at RBC Capital Markets, in a research note Monday. “For the Russell 2000, the rate of upward EPS estimate revisions is now above 50% again in September, meaning we are seeing more positive than negative revisions. The gap between small cap and large-cap continues to close on this metric.”
RBC said it is maintaining its recommendation of overweighting small-cap stocks. “Small-caps typically outperform in cutting cycles,” Calvasina said. “When investors start to adjust their portfolios to reflect their 2024 outlooks, we expect Fed cuts and riskier trades like small-caps to be a big part of the discussion.”
The Fed has raised its benchmark lending rate 11 times over the past 18 months to a level not seen for 22 years as it grapples with inflation still stubbornly above its long-run target of 2%. But economists expect the Federal Reserve to start cutting rates in the second quarter of next year.
Small-caps have trailed their larger peers this year and investors who want to tilt their portfolios toward small-caps after a period of large-cap outperformance, such as we have experienced lately, will need to weather the ups and downs.
The
Russell 2000
(ticker: RUT) index of companies with smaller market capitalizations has seen modest gains of about 5.37% so far this year while the
S&P 600
index (SML), which consists of smaller market value companies, is up 2.57%. The
S&P 500
index (SPX) has jumped 16.9% while the technology-heavy
Nasdaq Composite
(COMP) has surged 33%.
Another tailwind that could boost small-caps is a pick up in mergers and acquisitions. There may not be many deals in the offing right now, but Wall Street seems to be betting that conditions are about to become more favorable for deal makers. On Monday
J.M. Smucker Co.
(
SJM
), the food company famous for jams and jellies, reached an agreement to buy Hostess (TWNK) for about $5.6 billion, or $34.25 a share.
“I think we are going to see deal activity come back, and as that happens, that is something that should benefit small-caps more broadly” Kevin Dreyer, co-CIO for value at Gabelli Funds, told Barron’s. “As M&A activity comes back in this environment, I think that that’s going to disproportionately benefit small-cap stocks.”
Three stocks that Dreyer is optimistic about are sports nutrition and PowerBar maker
Bellring Brands
(BRBR),
Atlanta Braves
(BATRA), and
Treehouse Foods
(THS), the only major publicly traded pure play on private-label food products and a recent Barron’s stock pick.
Another factor favoring small-caps in the near term is their attractive valuations, said Bill Talbot, a senior portfolio manager and head of U.S. small-cap equities at Manulife Investment Management, in a recent note. “Small-caps’ recent underperformance relative to large-caps has left the Russell 2000 at its most inexpensive level relative to large-caps in more than two decades, dating to the period when the technology stock bubble burst in 2000,” he said.
Talbot said the investment teams “sees an abundance of bottom-up stock opportunities” in sectors such as technology, industrials, and healthcare.
Within tech, the firm is “persistently bullish” on the security software industry, where it expects sustained revenue growth with solid margins.
Regarding industrials, firm sees “the most favorable investment environment since the 2000s,” driven by capital spending on infrastructure and domestic manufacturing made possible in part by recent U.S. government stimulus spending, including the Inflation Reduction Act, which unlocked some $370 billion in funding for clean energy.
“Among the potential beneficiaries of this spending are engineering and construction companies, materials providers, and manufacturers of highly engineered industrial products,” said Talbot. In healthcare, demographic trends stemming from America’s aging population remain a long-term tailwind.
Write to Lauren Foster at [email protected]
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