Investors Are Playing The Small Caps Rally This Year

As the new year approaches, small-cap shares are rallying in 2023, attracting investors who are looking for growth opportunities.

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So far this year, small-capitalization companies, which do most of their business in the United States rather than abroad, have outperformed the broader market. S&P 600 Smallcap is up 10.2% through Wednesday, Russell 2000 small-cap is up 10%, and S&P 500 is up 7.5%.

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A 19.4% drop in the S&P 500 index was recorded last year, while a 21.6% drop in the Russell 2000 index was recorded.

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“We are in the midst of a regime change in the market, where small caps will do better than large caps,” said Francis Gannon, a co-chief investment officer of Royce Investment Partners, a small cap-focused investment firm.

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Prolonged underperformance

It has been a prolonged period of underperformance for small-cap stocks, according to Gannon. For instance, small-cap stocks returned an average annual total return of 4.1% through 2022, compared with 9.4% for the S&P 500. “I think that many of the winners of the past decade who took advantage of the low-interest rates, low inflation, and the low nominal growth of the past decade are not going to be the leaders going forward," he said.

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A recent rally has now convinced investors that small caps are on the verge of a prolonged period of outperformance. The following companies are their picks for the future:

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The Arizona-based Rogers Corporation ($2.8 billion market cap), a producer of engineered materials, has a strong growth outlook and solid management, according to Gannon. It initially sold its shares of Rogers when DuPont offered to buy it in late 2021 for $277 per share in cash, which Royce buys at significant discounts and intends to hold for three to five years. As a result of DuPont's withdrawal in November, Royce was able to establish a better position.

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The materials Rogers develops are used in wireless infrastructure, electric vehicles, smartphones, and apparel energy management, as well as other industrial applications. Since collapsing 56% in 2022, the stock has gained about 26%.

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As Forward Air pivots to handling shipping for high-value services, Gannon described the company as a smallcap with growth potential ($2.7 billion market cap). CEO Tom Schmitt expects "unusually slow" demand in the fourth quarter of 2023 to bleed into a few quarters of the following year (they fell more than 13% in 2022). 

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For Gannon, “it's all about focusing on the companies that have cash flow and earnings, and that leads us to the exposure to industrials and material businesses, some technology companies, financial companies [and] energy.” 

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Small-cap boom cycles last nearly a decade, Gannon said, anticipating years of higher returns ahead for small-cap stocks in a "declining inflationary environment."

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In addition, small caps are often quick to respond to economic activity since most of their sales are generated within the United States, whereas larger firms rely more on international markets.

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‘Massively outperform’

DWS Small Cap Core fund portfolio manager Michael Sesser believes small caps will outperform large caps over the next five to 10 years. Compared to the category and index, the Morningstar-rated, four-star fund has returned 10.5% annually over the past 10 years. Over the past decade, Morningstar says it lands in the 14th percentile of performance.

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Among Sesser's picks are Cantaloupe, a retail digital payments company with $373 million in market cap, and RadNet, a medical imaging provider with a market cap of $1 billion. They are both included in the Russell 2000 index.

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After plummeting 51% in 2022, Cantaloupe's stock price is up 21% this year. The company is rated a buy by all four sell-side analysts, and their average price target of $9 implies a potential upside of 71% from Wednesday's close. Due to record fourth-quarter revenue gains and Cantaloupe approaching 1.1 million active devices at the end of the year, DWS Small Cap believes the stock has potential for growth.

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RadNet's shares have gained about 11% this year. Among analysts, FactSet reports that the outpatient diagnostics provider has two buys and one hold, with an average price target of $34, giving it a potential upside of 63%. Sesser highlighted RadNet's ability to consolidate "mom-and-pop" imaging centers, as well as its joint ventures with hospitals.

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There are three other metallurgical coal producers owned by DWS Small Cap, Alpha Metallurgical Resources ($2.7 billion market cap), Arch Resources ($2.6 billion market cap), and Peabody Energy ($4.2 billion market cap), which serve the steel industry. There are a number of companies that have strong free cash flow yields and are indirectly benefited by the $1 trillion bipartisan infrastructure bill which was passed in November 2021 and the Inflation Reduction Act that was signed into law last August by President Biden.

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Bartlett Wealth Management's Craig Sarembock believes industrials and financials are the most promising sectors. Based on enterprise value to earnings before interest and taxes (EV/EBIT), small-cap companies trade at their lowest valuation in 20 years.

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Sarembock said multiple compression has been more prevalent in small-cap stocks than large-cap stocks over the past year. “It appears that they're even more attractive now than they were a decade ago."

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According to Jefferies' small- and midcap strategist Steven DeSanctis, growth companies are experiencing lower earnings and revenue numbers than cyclical companies.

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As a result of China's reopening and a weaker dollar, Jefferies recommends overweighting consumer discretionary and materials stocks. Financials were downgraded by Jefferies earlier this month after fourth-quarter earnings failed to meet expectations.

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