Small-cap stocks with potential

The dominant story of the market in the first half of 2023 was the dizzying rise of mega-cap tech stocks. About 10 mega-cap names accounted for an outsized proportion of the returns of the S&P 500^® Index.

While nothing is ever guaranteed in markets, some strategists say that this type of narrow market leadership—with just a few companies pulling the indexes higher—is unlikely to persist. Rather, we may be more likely to see that leadership broaden, with more stocks participating in gains.

Small-cap stocks, in particular, may be due for some catch-up. These are typically considered to be companies with a market capitalization of $300 million to $2 billion (or, depending on the specific definition used, potentially as large as $5 billion). After lagging large caps in recent years, small caps are currently selling at wide and attractive discounts relative to large-company stocks.

Indeed, we’ve already begun to see signs that small caps may be ready to join the front of the pack. While the Russell 2000 Index was essentially flat for the first 5 months of the year, it suddenly sprang to life in June and July—and as of mid-August had returned more than 10% year-to-date (though past performance is no guarantee of future results).

The small-cap discount

Even after their recent rally, small caps still have traded for a wide discount relative to stocks of larger companies. Denise Chisholm, Fidelity’s director of quantitative market strategy, says small caps were recently trading at close to their biggest discount to large caps on record, when measured by price-to-book-value.

When small caps have traded at this type of a discount in the past, they’ve historically gone on to deliver double-digit returns over the following 12 months, and in almost all such past periods have outperformed large caps, according to Chisholm’s research. If you slice the numbers another way and compare price-earnings ratios of profitable small caps (about one-third of Russell 2000 companies lose money) to large caps, they’re trading at about a 30% discount—the widest gap since the peak of the tech bubble in 2000.

Fidelity managers on the ground are observing the same dynamic. “High-quality small caps with good products are very attractive,” says Shadman Riaz, lead manager of Fidelity^® Stock Selector Small Cap Fund (). Due to waning interest from investors and a decline in the number of analysts following small companies, he says that small caps are “underfollowed and underloved, which has created a good setup for them.”

A different investable universe

When drilling into specific small-cap names, investors should keep in mind that the makeup of the small-company universe is quite different from the more familiar landscape of large caps. For example, the largest sector is industrials, which accounts for more than 18% of the Russell 2000 but only 9% of the S&P 500. And tech stocks have a much smaller presence—accounting for just 13% of the Russell 2000, compared with 28% for the S&P.¹

Another difference is that small caps tend to have much less overseas exposure than large companies. About 40% of revenues for large-cap Russell 1000 companies are generated abroad, more than twice the ratio for companies in the small-cap Russell 2000 Index, says Riaz. “Small-cap companies are primarily US or North American-centric,” he says.

This domestic focus can come with some potential advantages. “There’s no global ‘noise,’” says Riaz. It’s also easier for analysts and managers to visit company facilities and conduct rigorous checks of domestic sales channels—enhancing bottom-up analysis, he says. In addition, says Derek Janssen, comanager of Fidelity^® Small Cap Discovery Fund (), the trend of bringing manufacturing production back home (i.e., reshoring) should be more of a tailwind for small companies, which never did much outsourcing in the first place.

Plays on US economic resiliency

One key reason why the US economy still hasn’t tipped into recession has been the resiliency of the US consumer (personal consumption accounts for more than two thirds of US economic output²). Fox Factory ()³ is one company that has benefited from sturdy consumption. Georgia-based Fox makes and sells performance-enhancing components for off-road vehicles, trucks, motorbikes, cars, and boats.

Sales of RVs surged during the pandemic and then fell off, which hammered some stocks. Riaz thinks the cycle will normalize and that demand for these vehicles will bounce back. “US consumer habits don’t actually change that much,” over the long term, he says. A company that has illustrated this theme is Patrick Industries (), which makes components for recreational vehicles (RVs), marine transportation, and manufactured housing.

Another robust area of the US economy has been the labor market, with unemployment still below 4% as of July 2023. But the stock market has nevertheless punished the share prices of staffing companies, perhaps due to investors’ economic angst. Janssen has spotted potential value in professional staffing businesses that cater to the technology sector, a long-term growth area. Two examples of tech staffing companies that have illustrated this thesis are KForce (),⁴ which serves 3,000 clients and for whom technology accounts for 90% of business,⁵ and ASGN (),⁶ which provides IT consulting services to the federal government and commercial clients.

Opportunity amid volatility and disruption

Industries experiencing volatility this year—such as regional banks and commercial real estate—or ones being transformed by technological disruption (e.g., artificial intelligence, or AI) can be natural places to search for value in small caps.

Some investors sold regional banks indiscriminately in the wake of the closures earlier this year. Janssen has looked through the impacted stocks to identify regional banks with relatively sturdy, low-cost deposit bases and less exposure to nonperforming loans. One bank that has exemplified this thesis is Cadence Bank (),⁷ headquartered in Tupelo, Mississippi, which merged with a Houston-based bank in 2021. The merger combined “sticky” deposits from a less-competitive market in Mississippi with faster-growing markets, including Houston, for the loan book.

The post-pandemic tribulations of empty downtown office space have been well publicized. Janssen says this has created potential opportunity in beaten down commercial real estate broker stocks. For one thing, he says commercial real estate encompasses much more than just office space, as it also includes healthier sectors such as residential, industrial, retail, and hotels. For another, brokers make their money from transaction volume more than from prices. The number of forced sellers of downtown towers is expected to pick up when owners face maturing loans or a much higher cost of refinancing debt in coming months. Two commercial real estate brokers that Janssen has identified are Jones Lang LaSalle () and Cushman & Wakefield (),⁸ both of which operate globally.

Finally, consider AI, one of the most significant themes driving the market this year. The winners and losers are hard to predict in such a rapidly evolving space, but that doesn’t stop investors from placing bets on the future. Riaz thinks the stocks of some IT service companies have been punished on the belief that AI will negatively impact them. He thinks the truth is more nuanced—that AI will take years to disrupt the IT service industry, and that some of the affected players could actually turn out to be AI winners.