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Small companies with big potential

Key takeaways

  • Small caps were recently priced at a significant discount to large-company stocks, and analysts suggest they could see a sizeable earnings rebound this year.
  • Those factors, combined with a potential catalyst from any eventual cut in rates, could be creating a constructive setup for small caps.
  • Fidelity portfolio managers have uncovered potential opportunities among multiple sectors, including consumer discretionary, industrials, and energy.

So far, market action in 2024 has largely resembled that of last year. A relative handful of mega-cap tech stocks have powered returns of the S&P 500® Index, led in particular by companies at the forefront of advances in artificial intelligence.

While precise market timing is always hard to predict, many strategists believe this narrow market leadership will eventually broaden, and that a wider range and number of stocks may start to participate in market gains. Small-cap stocks are one asset class that may be due for some catch-up.

In recent weeks, there’s already been some evidence of a broadening as the S&P 500 Equal Weight Index (which gives a greater weighting to smaller companies and less weighting to the largest companies, relative to its better-known cap-weighted counterpart) finally struck new all-time highs for the first time in more than 2 years.

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A skewed risk-reward tradeoff

Small caps could still have miles to go to catch up to the pack. While major large-cap indexes such as the S&P, Nasdaq, and the Dow Jones have set record high after record high this year, as of mid-March the Russell 2000 Index of small companies was still about 18% below its all-time peak, which it set in November 2021.

Of course, the upside of sluggish performance is often more attractive valuations. “The valuation gap between small caps and large caps has been extreme,” says Denise Chisholm, Fidelity’s director of quantitative market strategy. Based on yardsticks such as price-to-book value, Chisholm calculates that, relative to large caps, small caps were recently in the bottom decile of their historical valuation range since 1990.

Moreover, valuation spreads among the Russell 2000 stocks are unusually wide (measured by the gap between the most- and least-expensive quartiles). “That’s an expression of fear,” says Chisholm, and indicates that small-cap stocks are priced in anticipation of a recession, and could have plenty of room for recovery in a soft-landing scenario. In the past, when valuation spreads have been this wide, the Russell 2000 has produced average returns of almost 40% over the following 12 months, according to Chisholm’s research.1

“In my opinion, your risk-reward tradeoff is very skewed in favor of small caps,” she says.

A potentially constructive setup from earnings and interest rates

To be sure, low valuations can become a trap if earnings erode. But analysts are expecting the opposite. After declining in 2023 on interest-rate pressures and bank-sector volatility (financials have a much larger weighting than for large-cap indexes), analysts expect earnings for small caps to jump 12% in 2024, compared to 9% for large caps.2

Any eventual cut in interest rates—which the Fed has indicated is likely to be on the table at some point this year—might only stack the odds further in small caps’ favor. “Small caps have historically benefited more than large caps from the first rate cut of a cycle,” says Chisholm, based on her research into market history. “And their advantage has been even greater when earnings also improved.” Historically, she says, small caps have beaten large caps more than 75% of the time in periods with similar market dynamics.3

Fidelity managers on the ground have been observing the same dynamic. “High-quality small caps with good products are very attractive in my opinion,” 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 unloved, which has created a good set up.”

One other factor potentially working in small caps’ favor has been the rebound of merger and acquisition activity that started in the fourth quarter of 2023. This is particularly important for valuations of smaller companies, since these are the ones that big companies tend to acquire or that investors seek to buy to take private.

“M&A has really picked up since the Fed indicated it may be done raising rates,” says Gabriela Kelleher, manager of Fidelity® Small Cap Value Fund (). “This helps to put a floor under the valuation of small caps.”

Fund top holdings4

Top-10 holdings of the Fidelity® Small Cap Value Fund () as of as of December 29, 2023:

  • 2.6% – Brookfield Infrastructure ()
  • 2.4% – Eastern Bankshares Inc. ()
  • 2.2% – US Foods Holding Corp. ()
  • 2.2% – Brunswick Corp. ()
  • 2.1% – Lumentum Holdings Inc. ()
  • 2.1% – Insight Enterprises Inc. ()
  • 2.0% – Jones Lang LaSalle Inc. ()
  • 1.9% – Cadence Bank ()
  • 1.9% – First American Financial Corp. ()
  • 1.9% – Concentrix Corp. ()

(See the most recent fund information.)

Investing in the American consumer

There’s an old saying in investing that you should “never bet against the American consumer.” Indeed, the surprising strength and resilience of US consumer spending has been widely credited with helping to keep recession at bay in the past year. Both Kelleher and Riaz have found compelling opportunities recently in the consumer discretionary sector, which encompasses companies that cater to “wants” rather than “needs” of consumers (and which was one of the top-performing sectors last year).

Brunswick (), which makes high-end leisure boats such as Boston Whaler and Bayliner, has illustrated the sturdy demand for consumer durables. Founded in 1845 by a Swiss immigrant, Brunswick has raised profitability in recent years, according to Kelleher, by focusing more on higher-margin marine engines, which include its Mercury brand. Another consumer discretionary firm she has recently found compelling is Canada-based BRP (),5 formerly known as Bombardier Recreational Products. BRP specializes in recreational, or so-called powersports vehicles such as snowmobiles, all-terrain vehicles, and personal watercraft.

Brunswick and BRP are both venerable companies; SharkNinja ()6 exemplifies a young, innovative consumer-products firm whose management, says Riaz, “focuses on new products meeting unmet customer needs.” Perhaps best known for its Shark brand portable vacuum cleaners, SharkNinja makes everything from blenders and air fryers to hair dryers and cleaning appliances. The Needham, Massachusetts-based product-design outfit holds more than 3,000 patents and has historically plowed at least 5% of sales back into research and development.7

Fund top holdings4

Top-10 holdings of the Fidelity® Stock Selector Small Cap Fund () as of as of December 29, 2023:

  • 1.5% – Academy Sports & Outdoors Inc. ()
  • 1.5% – Fabrinet ()
  • 1.3% – Simpson Manufacturing Co. ()
  • 1.3% – SPX Technologies Inc. ()
  • 1.3% – Insight Enterprises Inc. ()
  • 1.2% – Federal Signal Corp. ()
  • 1.2% – Synovus Financial Corp. ()
  • 1.1% – Advanced Energy Industries Inc. ()
  • 1.1% – Commercial Metals Co. ()
  • 1.1% – Rush Enterprises Inc. ()

(See the most recent fund information.)

Industrial, tech, and energy needs

Riaz has also been looking for potential beneficiaries of the big-picture shifts happening in the US economy. He’s been finding them in the industrials sector, which is the largest sector weighting in the small-cap universe, as well as in the tech sector.

“Trends that could benefit industrials include onshoring, fluid global supply chains, infrastructure spending, cloud computing, data center buildouts, as well as new manufacturing facilities that are increasingly being built in the Southeast of the US,” he says.

Two potential beneficiaries he’s identified are Diodes ()8 and Allegro MicroSystems ().9 Diodes makes a broad range of semiconductors, sensors, and switches that go into consumer, industrial, networking, and other communications products. Allegro also supplies a variety of integrated circuits but is more focused on the automotive industry, which has had a growing appetite for microchips.

Riaz also feels that securing a reliable supply of energy—including both fossil fuels and renewable energy—may be an enduring theme that could continue to drive investment results for years to come. “I believe that we’re in a world that is fundamentally short of energy, and the transition to clean energy will be more expensive and take longer than people realize,” he says. Since it’s gotten harder to squeeze additional oil out of resources such as US and Canadian shale formations, oil equipment and services that can boost shale productivity have been in demand.

Two examples of this theme have been Liberty Energy ()10 and Cactus ().11 Liberty provides services and technology such as for hydraulic fracturing to North American producers of shale oil. Cactus, which designs and makes wellhead and pressure-control equipment for onshore and offshore oil and gas drilling, operates globally.

Nextracker ()12 has exemplified how technology may be able to boost the efficiency of renewables. The firm supplies solar trackers (including software) to utility-scale solar plants to maximize power generation in new and existing plants. Riaz sees solar trackers as a growth industry with potentially a long runway in front of it.

Finding investing ideas

Fidelity offers a variety of mutual funds and ETFs that focus on small-cap companies, including the following:

Fidelity small-cap mutual funds:

  • Fidelity® Small Cap Discovery Fund ()
  • Fidelity® Small Cap Growth Fund ()
  • Fidelity® Small Cap Stock Fund ()
  • Fidelity® Small Cap Value Fund ()
  • Fidelity® Stock Selector Small Cap Fund ()

Fidelity small-cap ETFs:

  • Fidelity® Enhanced Small Cap ETF ()
  • Fidelity® Fundamental Small-Mid Cap ETF ()
  • Fidelity® Small-Mid Multifactor ETF ()

Investors can search for fund investing ideas from Fidelity and other fund providers with Fidelity’s Mutual Fund Evaluator or ETF/ETP screener. Those interested in individual stocks can research small-cap investment ideas with Fidelity's Stock Screener.

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1. Based on average price-to-book ratios of the least-expensive and most-expensive quartiles in the Russell 2000 from 1990 through November 2023. In 12-month periods following valuation spreads of similar magnitudes, the Russell 2000 produced average historical returns of 38%. Sources: Haver Analytics, FactSet, Fidelity Investments, as of November 30, 2023. 2. Based on analyst estimates of 2024 earnings-per-share for Russell 2000 companies, versus S&P 500 companies. Source: Factset. Data as of March 14, 2024. 3. Based on an analysis of data from 1970 through September 30, 2023, looking at the odds of outperformance in 12-month periods after periods of earnings acceleration and falling interest rates. Data analyzed quarterly. Sources: Haver Analytics, FactSet, Fidelity Investments. 4. 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. 5. Fidelity® Small Cap Value Fund (FCPVX) held a 0.139% position in this stock as of December 29, 2023. Fidelity® Stock Selector Small Cap Fund (FDSCX) held a 0.208% position in this stock as of December 29, 2023. 6. Fidelity® Stock Selector Small Cap Fund (FDSCX) held a 0.776% position in this stock as of December 29, 2023. 7. Sources: “Our company,” SharkNinja, accessed on March 12, 2024, “SharkNinja Reports Fourth Quarter and Full Year 2023 Results,” SharkNinja, February 15, 2024, 8. Fidelity® Stock Selector Small Cap Fund (FDSCX) held a 0.44% position in this stock as of December 29, 2023. Fidelity® Small Cap Value Fund (FCPVX) held a 0.082% position in this stock as of December 29, 2023. 9. Fidelity® Stock Selector Small Cap Fund (FDSCX) held a 0.269% position in this stock as of December 29, 2023. 10. Fidelity® Stock Selector Small Cap Fund (FDSCX) held a 0.967% position in this stock as of December 29, 2023. 11. Fidelity® Stock Selector Small Cap Fund (FDSCX) held a 0.585% position in this stock as of December 29, 2023. Fidelity® Small Cap Value Fund (FCPVX) held a 0.572% position in this stock as of December 29, 2023. 12. Fidelity® Stock Selector Small Cap Fund (FDSCX) held a 0.197% position in this stock as of December 29, 2023.

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

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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. The trademarks and service marks appearing herein are the property of their respective owners. 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.

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