Small-Cap Stocks Can Fill the Mag 7 Market Void: 4 to Play

The reign of the Magnificent 7 stocks—the titanic technology enterprises that propelled market gains for much of the previous year—seems to be encountering a period of lethargy. As these large-cap stocks falter, the critical question naturally arises: will their retreat catalyze growth in other sectors, thereby sustaining the overall health of the markets, or will it demand a significant market correction before new growth drivers emerge? Mark Sherlock, head of a U.S. small and mid-cap fund at Federated Hermes, posits that the latter scenario may present an unforeseen opportunity.

According to Sherlock, current high expectations for earnings among larger firms starkly contrast with the relatively subdued outlook for small-cap stocks. This divergence creates fertile ground for smaller firms to exploit “low expectations,” potentially leading to substantial gains. Although acknowledging that larger-cap stocks have outperformed over the past two years, with the S&P 500 benefitting from the “Mag 7” surge yielding annual gains of over 20%, Sherlock emphasizes that the next few years could witness a resurgence in SMID (Small and Mid-cap) stocks.

Three Reasons to Consider SMID Stocks

Here are three primary reasons Sherlock believes there is potential for small-cap stocks to outperform in the coming years:

1. Relative Valuation

Large-cap stocks have reached dizzying valuation heights, while smaller companies, which have generally been on the back foot over the past few years, can be found at more attractive valuations. Many small-cap industries, such as real estate, have already traversed effective recessionary territory due to heightened interest rates from the Federal Reserve. This market dynamic offers a promising entry point for discerning investors.

2. Economic Exposure

Moreover, small-cap businesses are more intimately tethered to the domestic economy compared to their bigger counterparts that often derive significant revenue from international sales. As the U.S. economy shows resilience, investing in smaller companies might yield more fruitful returns reflective of this domestic growth.

3. Mergers and Acquisitions Potential

Lastly, Sherlock surmises that attractive valuations among small-cap firms could trigger a wave of mergers and acquisitions in the near future. The prevailing backdrop of rising interest rates and shifting economic trends may entice larger entities to seek out smaller, undervalued firms.

Political Landscape and Its Implications

Curiously, the forecast for small-cap performance is unlikely to be heavily influenced by the upcoming election in November. A divided government is generally perceived favorably within financial markets, as it fosters a sense of stability. As Sherlock articulates, “The U.S. is an economic juggernaut that keeps on chugging. The winner of the election could well be the economy.”

Investment Strategies and Notable Stocks

With a “tortoise beats the hare” investment philosophy, Sherlock seeks firms with sound cash flow and strong competitive barriers, often holding onto these investments for about five years. This long-term focus provides what he describes as “evergreen, sleep-at-night exposure to the U.S. economy.”

Highlighted Stocks

Power Integrations

Not all semiconductor firms are giants like Intel and Nvidia. Power Integrations specializes in high-voltage power conversion units for electric vehicles and city infrastructure. Despite a decline from over $100 in 2021 to around $63 today, the company’s quest for energy-efficient solutions positions it for a potential rebound. Its current valuation is around 38 times forward earnings, and 5 of 7 analysts rate it a Buy.

Martin Marietta

Another stock poised for growth is Martin Marietta, which operates rock mines for infrastructure materials. The company is likely to benefit from increased construction activity fueled by the migration to faster-growing regions and efforts to localize supply chains. Trading at approximately 31 times forward earnings, its stock has gained 23% over the past year, with analysts projecting an 18% upside.

Trex and Fortune Brands

In the home improvement sector, companies like Trex and Fortune Brands could find themselves at an inflection point as consumers resume investment in their homes following the pandemic’s highs. As the retail environment normalizes, these companies may emerge with fresh opportunities for growth.

Conclusion

The current market landscape offers a compelling case for investors to pivot towards small-cap stocks as the larger market indices face saturation and overvaluation issues. If a correction is at hand, or if one is seeking opportunities not yet affected by high earnings expectations, small-cap firms present an attractive alternative.