Small-Cap Stocks Finally Break Out, Offering Hope for Investors
After years of underperformance, small-cap stocks are finally showing signs of life. While the broader market has been dominated by a handful of artificial intelligence giants, the Russell 2000, a benchmark for small-cap stocks, has languished. However, a surge in July, with a gain of over 9%, has sparked optimism. This breakout, fuelled by a combination of improving interest rates, a pick up in mergers and acquisitions, and the reshoring of supply chains, could signify a long-awaited turnaround for the asset class.
Key Takeaways:
- Small-cap stocks are finally emerging from a decade of underperformance, buoyed by a surge in July, with the Russell 2000 gaining over 9%.
- Improved interest rate outlook, coupled with lower inflation, have made small caps more attractive to investors.
- Reshoring of supply chains is creating opportunities for domestically focused small-cap companies, particularly in sectors like semiconductors and pharmaceuticals.
- Valuation gap between small-cap stocks and large caps is becoming more favorable, leading to potential outperformance.
A Long-Awaited Turnaround
For over a decade, investors have witnessed small-cap stocks struggling to keep pace with their larger counterparts. This has led some analysts to believe that the dominance of "Magnificent Seven" tech giants has stifled the growth of smaller companies. However, this recent surge has renewed confidence in the small-cap sector.
"This breakout only tells me that finally you’re gonna get some rational investors back in the markets," says Nicholas Galluccio, portfolio manager at Teton Westwood. He believes this could be the start of a multiyear shift in performance for small-cap stocks.
What’s Driving the Rally?
Several factors are converging to create a positive environment for small-cap stocks:
- Interest Rate Outlook: As the Federal Reserve appears to be nearing the end of its rate-hiking cycle, investors are becoming more optimistic about the prospects for interest rate sensitive asset classes like small caps.
- Inflation: With inflation easing, small-cap companies, with their greater exposure to the domestic economy, are expected to benefit from a more favorable economic climate.
- Reshoring: The trend of bringing manufacturing and production back to the US is creating opportunities for domestically focused small-cap companies, particularly in sectors like semiconductors and pharmaceuticals.
- Valuation Gap: The historical valuation gap between small caps and large caps has widened in recent years, making small caps more attractive due to their potential for upside growth.
A Look at the Winners
Specific examples illustrate how small-cap companies are benefitting from these trends:
- Summit Materials: This construction materials company is poised to capitalize on reshoring projects, such as the Panasonic electric vehicle battery plant in Kansas.
- Cohu: This wafer handling company offers a compelling investment opportunity due to its strong earnings power, lack of debt, and abundant cash reserves.
A Multi-Year Bull Case?
While small-cap stocks have seen a strong rally in July, several investors believe this could be the start of a long-term outperformance cycle.
"It is cyclical over time, though," says Mike Rode, an analyst at American Century Investments. He predicts a 12 to 24-month period of outperformance for small caps.
Galluccio, however, is even more optimistic, stating, "I think small caps stand to outperform for the next three years."
Navigating the Risks
While small caps offer potential for substantial growth, they also carry inherent risks:
- Liquidity: Small-cap stocks are generally less liquid than their large-cap counterparts, making it more difficult to buy and sell them quickly.
- Economic Sensitivity: Small-cap companies are more closely tied to the performance of the broader economy, making them vulnerable to economic downturns.
To mitigate these risks, investors can focus on quality companies with strong balance sheets and high returns on capital.
The Future of Small Caps
The recent surge in small-cap stocks has rekindled interest in the asset class. Investors are increasingly recognizing that quality companies, regardless of size, can offer attractive investment opportunities.
This turnaround highlights the importance of diversification and suggests that the landscape of investment opportunities is constantly evolving. As reshoring continues and interest rates moderate, small caps are positioned to play a significant role in the market for years to come.
