Estimate Time7 min

Small-cap stocks with potential

Key takeaways

  • Small caps were recently trading at substantial and attractive discounts relative to large-company stocks, and could be due for a stretch of outperformance.
  • These companies are generally more closely tied to the domestic economy than large and mega-cap names, and so could benefit from continued US economic resiliency.
  • Fidelity portfolio managers have found opportunities among companies that cater to US consumers and the US job market.
  • Disruption and volatility in commercial real estate, regional banks, and IT service providers have also created potential opportunity.

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).

Sign up for Fidelity Viewpoints weekly email for our latest insights.

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.

Fund top holdings*

Top-10 holdings of the Fidelity® Stock Selector Small Cap Fund () as of June 30, 2023:

  • Commercial Metals Co. ()
  • Atkore Inc. ()
  • Academy Sports & Outdoors Inc. ()
  • Denbury Inc. ()
  • Brookfield Infrastructure ()
  • SPX Technologies Inc. ()
  • Northern Oil and Gas Inc. ()
  • Axcelis Technologies Inc. ()
  • Advanced Energy Industries Inc. ()
  • Emcor Group Inc. ()

(See the most recent fund information.)

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.

Fund top holdings*

Top-10 holdings of the Fidelity® Small Cap Discovery Fund () as of June 30, 2023:

  • Insight Enterprises Inc. ()
  • LGI Homes Inc. ()
  • First American Financial Corp. ()
  • Shawcor Ltd. ()
  • Enstar Group Ltd. ()
  • FirstCash Holdings Inc. ()
  • Jones Lang LaSalle Inc. ()
  • Patrick Industries Inc. ()
  • Performance Food Group Co. ()
  • Sitio Royalties Corp. ()

(See the most recent fund information.)

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.

Research stocks, ETFs, or mutual funds

Get our industry-leading investment analysis, and put our research to work.

Find stocks

Match ideas with potential investments using our Stock Screener.
* Any holdings, asset allocation, diversification breakdowns or other composition data shown are as of the date indicated and are subject to change at any time. They may not be representative of the fund's current or future investments. The Top Ten holdings do not include money market instruments or futures contracts, if any. Depository receipts are normally combined with the underlying security. Some breakdowns may be intentionally limited to a particular asset class or other subset of the fund's entire portfolio, particularly in multi-asset class funds where the attributes of the equity and fixed income portions are different. Under the asset allocation section, international (or foreign) assets may be reported differently depending on how an investment option reports its holdings. Some do not report international (or foreign) holdings here, but instead report them in a "Regional Diversification" section. Some report them in this section in addition to the equity, bond and other allocation shown. Others report international (or foreign) holding as a subset of the equity and bond allocations shown. If the allocation without the foreign component equals (or rounds to) 100%, then international (or foreign) is a subset of the equity and bond percentage shown. 1. Sector weighting data as of July 31, 2023 for the S&P 500 and June 30, 2023 for the Russell 2000. “S&P 500 factsheet,” S&P Dow Jones Indices, accessed on August 3, 2023. “Index factsheet: Russell 2000 Index,” FTSE Russell, accessed on August 3, 2023. 2. “Share of gross domestic product: Personal consumption expenditures,” FRED Economic Data, St. Louis Fed. Data as of July 27, 2023. 3. Fidelity® Stock Selector Small Cap Fund (FDSCX) held a 0.49% position in this stock as of May 31, 2023. 4. Fidelity® Small Cap Discovery Fund (FSCRX) held a 1.67% position in this stock as of May 31, 2023. 5. “Annual Letter from the President & CEO,” KForce, March 2023, 6. Fidelity® Small Cap Discovery Fund (FSCRX) held a 1.60% position in this stock as of May 31, 2023. Fidelity® Stock Selector Small Cap Fund (FDSCX) held a 0.65% position in this stock as of May 31, 2023. 7. Fidelity® Small Cap Discovery Fund (FSCRX) held a 1.78% position in this stock as of May 31, 2023. 8. Fidelity® Small Cap Discovery Fund (FSCRX) held a 1.45% position in this stock as of May 31, 2023. Fidelity® Stock Selector Small Cap Fund (FDSCX) held a 0.21% position in this stock as of May 31, 2023.

Stock markets are volatile and can fluctuate significantly in response to company, industry, political, regulatory, market, or economic developments. Investing in stock involves risks, including the loss of principal.

The securities of smaller, less well known companies can be more volatile than those of larger companies.

The financials industries are subject to extensive government regulation, can be subject to relatively rapid change due to increasingly blurred distinctions between service segments, and can be significantly affected by availability and cost of capital funds, changes in interest rates, the rate of corporate and consumer debt defaults, and price competition.

As with all your investments through Fidelity, you must make your own determination whether an investment in any particular security or securities is consistent with your investment objectives, risk tolerance, financial situation, and evaluation of the security. Fidelity is not recommending or endorsing this investment by making it available to its customers.

Past performance is no guarantee of future results.

Views expressed are as of the date indicated, based on the information available at that time, and may change based on market or other conditions. Unless otherwise noted, the opinions provided are those of the speaker or author and not necessarily those of Fidelity Investments or its affiliates. Fidelity does not assume any duty to update any of the information.

The S&P 500® Index is a market capitalization-weighted index of 500 common stocks chosen for market size, liquidity, and industry group representation to represent US equity performance. The Russell 2000 Index is a market capitalization-weighted index designed to measure the performance of the small cap segment of the US equity market. It includes approximately 2,000 of the smallest securities in the Russell 3000 Index. Before investing, consider the funds' investment objectives, risks, charges, and expenses. Contact Fidelity for a prospectus or, if available, a summary prospectus containing this information. Read it carefully.

Fidelity Brokerage Services LLC, Member NYSE, SIPC, 900 Salem Street, Smithfield, RI 02917