Small-Cap Stocks: Strategies for a Challenging Market

Current Landscape of Small-Cap Stocks

As we navigate the complexities of the investment landscape in 2024, small-cap stocks have shown a remarkable yet inconsistent performance. The S&P Small Cap 600 Index recently demonstrated a 16% increase from its lowest point earlier this year in April, peaking this month at a closing high of 1442. This growth, however, has been characterized by brief rallies, often sparked by fleeting surges in economic confidence.

Several macroeconomic factors have influenced these movements. The Federal Reserve’s aggressive interest rate cuts in September provided a backdrop for optimism, with continued economic growth recorded in the low single digits. Furthermore, the ongoing political landscape, specifically the rising chances of former President Donald Trump’s reelection, has stirred expectations of potential tax cuts—an additional layer of complexity for small-cap investors to consider.

The Challenges Small-Cap Stocks Face

Despite these fleeting rallies, small-cap stocks have struggled to maintain momentum. Each time the index approaches its recent highs, investor enthusiasm seems to wane; there simply aren’t sufficient buyers to propel it higher. With a record close of 1465 achieved in late 2021, the current performance feels increasingly lackluster.

One significant challenge is the historical valuation divergence between the S&P Small Cap 600 and the S&P 500. Even though small caps remain undervalued, they also bear a greater economic risk, particularly concerning rising interest rates. As the economy grows and associated government spending increases—regardless of whether it’s under a Trump or Kamala Harris administration—inflation could remain stubbornly above the Federal Reserve’s targeted 2%. This scenario could deter the Fed from further rate cuts, which would adversely impact the economy.

Moreover, small-cap companies tend to have higher volumes of variable-rate debt compared to their larger counterparts, making them particularly vulnerable to profit declines should borrowing costs rise.

Shifting Strategies: Selecting Individual Stocks

Given the current dynamics, a passive approach of buying into the entirety of the S&P 600 is proving less fruitful. Instead, investors would do well to pivot toward a more strategic method: seeking out individual stocks with solid earnings trends while also maintaining reasonable valuations. Scott Chronert, a strategist at Citi, emphasizes the appeal of small and mid-cap stocks as attractive opportunities for selective investment.

Citi has identified several small and mid-cap stocks—companies valued under $20 billion—that are rated as Buy by analysts and are forecasted to yield returns exceeding 10%. Noteworthy examples include:

– **Texas Roadhouse (TXRH)** – a $12 billion market cap restaurant operator
– **Ally Financial (ALLY)** – valued at $10 billion in the lending industry
– **XPO (transport company)** – with a market cap of $14 billion
– **Eagle Materials (EXP)** – a building-materials company valued at $9 billion

Identifying High-Potential Stocks

Further analysis by Barron’s has narrowed the prospect list to companies with stable or rising earnings forecasts since the start of 2024, even in the face of declining aggregate profit forecasts for the S&P 600 index. The criteria for selection included stocks trading at no more than 15 times forward earnings, significantly below the approximately 22 times for the S&P 500.

Among those highlighted is **Unum Group**, an $11 billion insurer whose earnings estimates have increased by 9% this year, trading at just seven times earnings. Another interesting case is **Abercrombie & Fitch (ANF)**, with a market cap of $7 billion and trading at 12 times expected earnings for the coming 12 months. Analysts have upgraded sales expectations substantially for Abercrombie, anticipating continued growth in earnings along with improved profit margins and marketing expenditure that enables market share expansion.

Conclusion: A Tactical Approach to Investing

The current climate emphasizes the need for more discerning stock selection among small-cap investors. While the broader index may appear attractively priced, the volatility and underlying economic pressures necessitate a measured approach centered on identifying individual stocks with strong potential rather than relying on market averages. As economic conditions evolve, maintaining a strategic focus on performance-driven investments will be paramount in capitalizing on the opportunities within the small-cap sector.