Small-Cap Stocks Have Been Big Winners. Why They Can Keep Outperforming.

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Good things are supposed to come in small packages, but that hasn’t been the case for small-company stocks this year. That could be about to change.

The recent bear market hit small-capitalization stocks particularly hard. The

Russell 2000
index dropped 32% from its all-time closing high in November through its June 2022 low. That’s far worse than the

S&P 500’s
24% drop from peak to trough. But it makes sense. Small companies are hit harder by rising rates and a slowing economy than their larger counterparts, and it has been a long time since the Fed has been forced to raise rates as quickly as it has this year.

Now, the Fed appears ready to slow down its pace of rate increases—the fed-funds futures market is pricing in just a 26% chance of a three-quarter point hike at its next meeting in September, down from about 60% just one week ago—and those falling expectations have been great news for small-caps. The Russell 2000 is up 14.3% from its mid-June low, outpacing the S&P 500’s 12.6% gain over the same period.

Small-caps appear to be following a familiar pattern, underperforming before a recession and then outperforming coming out of one. That was the case in 1990, 2001, 2008, and 2020, according to Lori Calvasina, chief U.S. equity strategist at RBC Capital Markets, when small-caps fell more than large-caps heading into the recessions, before outperforming on the way out.

“We now feel comfortable telling investors to overweight small-caps,” she writes.

Of course, for that to work, small-caps have had to price in both the Fed rate hikes and the recession that typically follows. Their valuations suggest they already have. The Russell 2000 recently traded at just 13 times 12-month forward earnings, near the lowest it has hit since the 2008-09 financial crisis, according to

Bank of America
.
“[We] think risks are largely discounted,” writes BofA Securities strategist Jill Carey Hall.

Still, there’s a lot of junk in small-cap indexes, and investors should look for quality companies. Jefferies strategists prefer “growth at a reasonable price,” a strategy that has performed well during the recent market rally. Such stocks have strong earnings-growth expectations, but are profitable and probably won’t need to raise capital if the economy takes another turn for the worse. The strategists found 18 examples, including

Armstrong World Industries

(AWI) and

Capri Holdings

(CPRI).

Yeti Holdings

(YETI) looks particularly interesting. The $4.4 billion maker of high-end coolers has taken market share from Igloo and

Newell Brands

’ (NWL) Coleman with patented technology that allows it to keep food and drink cool for a longer time, explains Miles Lewis of Royce Investment Partners, which owns Yeti. The company is still growing, with cooler sales expected to grow in the midteens in 2023. And it has added new products, which should alleviate worries that its growth will decelerate.

“People think they’re [Yeti] a one-trick pony,” Lewis says. “Now they have a drinkware business.”

Sales are expected to compound annually at a 12% rate over the next two years to $2.1 billion, according to FactSet. That would bring earnings per share up about 15% each year to $3.82 by 2024, which could drive the stock higher. At $50.77, it trades at about 15 times forward earnings, just over half of its five-year average of 26 times.

There’s nothing better than small companies with big prospects.

Write to Jacob Sonenshine at [email protected]