Small-Cap Stocks: A Struggling Sector with Untapped Potential

Small market-capitalization stocks have had a challenging year, struggling to maintain momentum and sustain rallies despite sporadic surges fueled by optimism about the economy. With the S&P Small Cap 600 Index recently hitting a high of 1442 in 2024, many investors are reconsidering their approach to this sector, especially as it lags behind larger-cap indices.

Recent Performance and Economic Influences

The S&P Small Cap 600 Index has experienced a 16% rise from its lowest point earlier this year in April. The increase was primarily driven by optimism regarding economic growth and the Federal Reserve’s aggressive interest rate cuts implemented in September. There is also the rising likelihood of further tax cuts should former President Donald Trump regain office. However, as enticing as these rallies appeared, they have proven fleeting, often stalling when the index approaches its 2024 highs. The record close of 1465, reached in late 2021, continues to feel out of reach for small-cap stocks.

The Challenges Facing Small Caps

The main hurdle preventing the S&P 600 from making sustained gains lies in its historical valuation relative to the S&P 500. While small-cap stocks are generally considered undervalued compared to their larger counterparts, multiple economic factors could hinder growth potential. A thriving economy accompanied by government spending might keep inflation rates high, complicating the Federal Reserve’s efforts to manage interest rates. Moreover, smaller companies often carry a larger portion of variable-rate debt compared to their larger peers. This means that rising borrowing costs could disproportionately affect their earnings, leaving them more vulnerable to market fluctuations.

Strategizing Small-Cap Investments

Given these dynamics, a blanket approach to investing in the entire S&P 600 index merely based on its low valuations has proven to be ineffective. Instead, experts suggest a more strategic focus on selecting individual stocks that exhibit a combination of strong earnings growth and appealing valuations. As noted by Scott Chronert, a strategist at Citi, “Small/Mid Cap is an increasingly attractive opportunity set for stock selection.”

Identifying Promising Small and Mid-Cap Stocks

Citi analysts have identified several small and mid-cap stocks valued at less than $20 billion, which they rate as ‘Buy’ options and forecast returns of at least 10%. Some noteworthy names include:

• Texas Roadhouse (TXRH): A well-known restaurant operator with a market cap of $12 billion.
• Ally Financial (ALLY): A financial services company valued at $10 billion.
• XPO Logistics (XPO): A transportation and logistics firm with a market cap of $14 billion.
• Eagle Materials (EXP): A building materials company valued at $9 billion.

Narrowing the Focus

In addition to identifying stocks with potential for growth, it is essential to hone in on those companies whose earnings forecasts have either stabilized or improved throughout the year. In fact, Barron’s recommends selecting companies with forward earnings multiples not exceeding 15 times, which is significantly lower than the nearly 22 times average for the S&P 500.

One stellar example is Unum Group, an insurer valued at $11 billion with earnings estimates rising by 9% this year, trading at just seven times earnings. Meanwhile, Abercrombie & Fitch (ANF), a fashion retailer with a market cap of $7 billion, trades at 12 times expected earnings and has seen a remarkable uptick in sales forecasts and market share growth. Analysts project nearly a 75% increase in the company’s earnings estimates, highlighting Abercrombie’s robust performance in a challenging retail landscape.

Conclusion

Though small-cap stocks as a whole may seem stalled in their upward trajectory, the potential for substantial returns remains. Instead of passively investing in the entire S&P 600 index, savvy investors may find greater success in selectively picking companies exhibiting strong earnings trends and favorable valuations. As economic conditions evolve, identifying and investing in these hidden gems within the small-cap universe may be the key to achieving profitable results.