Small companies with big potential

Small caps may be overdue for a winning streak.

Key Takeaways

  • Small caps were recently priced at a significant discount to large-company stocks, and analysts suggest they could see a sizeable earnings rebound this year.
  • Those factors, combined with a potential catalyst from any eventual cut in rates, could be creating a constructive setup for small caps.
  • Fidelity portfolio managers have uncovered potential opportunities among multiple sectors, including consumer discretionary, industrials, and energy.

So far, market action in 2024 has largely resembled that of last year. A relative handful of mega-cap tech stocks have powered returns of the S&P 500® Index, led in particular by companies at the forefront of advances in artificial intelligence.

While precise market timing is always hard to predict, many strategists believe this narrow market leadership will eventually broaden, and that a wider range and number of stocks may start to participate in market gains. Small-cap stocks are one asset class that may be due for some catch-up.

In recent weeks, there's already been some evidence of a broadening as the S&P 500 Equal Weight Index (which gives a greater weighting to smaller companies and less weighting to the largest companies, relative to its better-known cap-weighted counterpart) finally struck new all-time highs for the first time in more than 2 years.

A skewed risk-reward tradeoff

Small caps could still have miles to go to catch up to the pack. While major large-cap indices such as the S&P, Nasdaq, and the Dow Jones have set record high after record high this year, as of mid-March the Russell 2000 Index of small companies was still about 18% below its all-time peak, which it set in November 2021.

Of course, the upside of sluggish performance is often more attractive valuations. "The valuation gap between small caps and large caps has been extreme," says Denise Chisholm, Fidelity's director of quantitative market strategy. Based on yardsticks such as price-to-book value, Chisholm calculates that, relative to large caps, small caps were recently in the bottom decile of their historical valuation range since 1990.

Moreover, valuation spreads among the Russell 2000 stocks are unusually wide (measured by the gap between the most- and least-expensive quartiles). "That's an expression of fear," says Chisholm, and indicates that small-cap stocks are priced in anticipation of a recession, and could have plenty of room for recovery in a soft-landing scenario. In the past, when valuation spreads have been this wide, the Russell 2000 has produced average returns of almost 40% over the following 12 months, according to Chisholm's research.1

"In my opinion, your risk-reward tradeoff is very skewed in favor of small caps," she says.

A potentially constructive setup from earnings and interest rates

To be sure, low valuations can become a trap if earnings erode. But analysts are expecting the opposite. After declining in 2023 on interest-rate pressures and bank-sector volatility (financials have a much larger weighting than for large-cap indexes), analysts expect earnings for small caps to jump 12% in 2024, compared to 9% for large caps.2

Any eventual cut in interest rates—which the Fed has indicated is likely to be on the table at some point this year—might only stack the odds further in small caps' favor. "Small caps have historically benefited more than large caps from the first rate cut of a cycle," says Chisholm, based on her research into market history. "And their advantage has been even greater when earnings also improved." Historically, she says, small caps have beaten large caps more than 75% of the time in periods with similar market dynamics.3

One other factor potentially working in small caps' favor has been the rebound of merger and acquisition activity that started in the fourth quarter of 2023. This is particularly important for valuations of smaller companies, since these are the ones that big companies tend to acquire or that investors seek to buy to take private.

Investing in the American consumer

There's an old saying in investing that you should "never bet against the American consumer." Indeed, the surprising strength and resilience of US consumer spending has been widely credited with helping to keep recession at bay in the past year. Fidelity managers on the ground have found compelling opportunities recently in the consumer discretionary sector, which encompasses companies that cater to "wants" rather than "needs" of consumers (and which was one of the top-performing sectors last year).

Brunswick (BC), which makes high-end leisure boats such as Boston Whaler and Bayliner, has illustrated the sturdy demand for consumer durables. Founded in 1845 by a Swiss immigrant, Brunswick has raised profitability in recent years, according to Kelleher, by focusing more on higher-margin marine engines, which include its Mercury brand. Another consumer discretionary firm she has recently found compelling is Canada-based BRP (DOOO),5 formerly known as Bombardier Recreational Products. BRP specializes in recreational, or so-called powersports vehicles such as snowmobiles, all-terrain vehicles, and personal watercraft.

Brunswick and BRP are both venerable companies; SharkNinja (SN)6 exemplifies a young, innovative consumer-products firm whose management focuses on new products meeting unmet customer needs. Perhaps best known for its Shark brand portable vacuum cleaners, SharkNinja makes everything from blenders and air fryers to hair dryers and cleaning appliances. The Needham, Massachusetts-based product-design outfit holds more than 3,000 patents and has historically plowed at least 5% of sales back into research and development.7

Industrial, tech, and energy needs

Fidelity managers have also been looking for potential beneficiaries of the big-picture shifts happening in the US economy. They have been finding them in the industrials sector, which is the largest sector weighting in the small-cap universe, as well as in the tech sector.

Two potential beneficiaries they have identified are Diodes (DIOD)8 and Allegro MicroSystems (ALGM).9 Diodes makes a broad range of semiconductors, sensors, and switches that go into consumer, industrial, networking, and other communications products. Allegro also supplies a variety of integrated circuits but is more focused on the automotive industry, which has had a growing appetite for microchips.

Fidelity managers also feel that securing a reliable supply of energy—including both fossil fuels and renewable energy—may be an enduring theme that could continue to drive investment results for years to come. Since it's gotten harder to squeeze additional oil out of resources such as US and Canadian shale formations, oil equipment and services that can boost shale productivity have been in demand.

Two examples of this theme have been Liberty Energy (LBRT)10 and Cactus (WHD).11 Liberty provides services and technology such as for hydraulic fracturing to North American producers of shale oil. Cactus, which designs and makes wellhead and pressure-control equipment for onshore and offshore oil and gas drilling, operates globally.

Nextracker (NXT)12 has exemplified how technology may be able to boost the efficiency of renewables. The firm supplies solar trackers (including software) to utility-scale solar plants to maximize power generation in new and existing plants. Fidelity managers see solar trackers as a growth industry with potentially a long runway in front of it.

Explore more market and investment insights from Fidelity's top thinkers here.


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