Small-cap stocks have faced challenges throughout the year, but there are indications that the tide is turning in their favor. One positive factor is the upward revision of earnings forecasts, as highlighted by RBC Capital Markets.
Lori Calvasina, head of U.S. equity strategy at RBC Capital Markets, stated in a recent research note that small-cap stocks are now benefiting from the growing optimism surrounding earnings. In September, the rate of upward EPS (earnings per share) estimate revisions for the Russell 2000 reached above 50%, indicating a higher number of positive revisions compared to negative ones. This narrowing gap between small caps and large caps indicates an encouraging trend.
Maintaining their recommendation to overweight small-cap stocks, RBC suggests that these stocks typically outperform during cutting cycles. Calvasina explains that as investors adjust their portfolios to align with their outlook for 2024, discussions will likely involve Federal Reserve (Fed) cuts and riskier trades such as small-caps.
The Fed’s recent actions, which included raising its benchmark lending rate multiple times over the past 18 months, may soon be reversed. Economists anticipate rate cuts by the Fed commencing in the second quarter of next year, boosting prospects for small-caps.
It is worth noting that small caps have lagged behind their larger counterparts this year. Investors looking to rebalance their portfolios by inclining towards small-caps must be prepared for potential volatility.
As of now, the Russell 2000 index, representing companies with smaller market capitalizations, has achieved moderate gains of approximately 5.37% year-to-date. Similarly, the S&P 600 index, consisting of smaller market value companies, has observed a growth of 2.57%. In contrast, the S&P 500 index has surged by 16.9%, while the technology-heavy Nasdaq Composite has soared by an impressive 33%.
In addition to upward earnings revisions, another factor that could provide a boost to small-caps is an increase in mergers and acquisitions activity. Though there may not be many ongoing deals at present, Wall Street seems optimistic that conditions will become more favorable for deal making. An example of this sentiment is J.M. Smucker Co., the renowned food company known for its jams and jellies, recently reaching an agreement to acquire Hostess for $5.6 billion, or $34.25 per share.
Deal Activity Set to Boost Small-Cap Stocks, Say Experts
“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,” said Kevin Dreyer, co-CIO for value at Gabelli Funds. “As M&A activity comes back in this environment, I think that that’s going to disproportionately benefit small-cap stocks.”
According to Bill Talbot, a senior portfolio manager and head of U.S. small-cap equities at Manulife Investment Management, small-caps are also favored due to their attractive valuations. The recent underperformance of small-caps relative to large-caps has led to the Russell 2000 being at its most inexpensive level relative to large-caps in more than two decades.
Manulife Investment Management’s investment teams are optimistic about several sectors. They see ample opportunities in technology, industrials, and healthcare.
In the technology sector, the firm is particularly bullish on the security software industry. They anticipate sustained revenue growth with solid margins.
As for the industrials, the outlook is favorable. The firm believes it is currently the most favorable investment environment in decades, driven by capital spending on infrastructure and domestic manufacturing facilitated by recent U.S. government stimulus programs.
In healthcare, demographic trends stemming from America’s aging population are viewed as a long-term tailwind.
These optimistic assessments suggest that small-cap stocks have strong potential for growth and should not be overlooked by investors.
