Many investors expect small-cap stocks to outperform in 2024, saying the prospect of easy monetary policy introduced by Federal Reserve Chairman Jerome Powell late last year will benefit interest-rate-sensitive asset classes. Instead, small caps spent the first half of the year doing what they’ve been doing for the past decade: falling behind. While the S&P 500 has surged to record highs this year on the back of a handful of artificial intelligence stocks, the small-cap Russell 2000 has stagnated over the past six months. But now, there seems to be a breakthrough. In July, the Russell 2000 rose more than 9%. Meanwhile, the S&P 500 was flat for the month. .RUT YTD Mountain Russell 2000 YTD An improving outlook for interest rates and inflation spurred gains in small-cap stocks as investors made long-term bets on the asset class. These investors expect historically large valuation gaps, increased M&A activity, and secular reshoring trends to support a multi-year performance turnaround for the asset class. “This breakout just tells me that eventually you’re going to get some rational investors back into the market,” said Nicholas Galluccio, a portfolio manager at Teton Westwood. The manager said his fund, TW Smallcap Equity Fund Class I, rose with the market. As of Wednesday, it was up 11.37% this year. The Russell 2000 Index rose 10%, with the Russell 2000 Index rising 11%. Sustainable Rally Small-cap stocks have underperformed over the past decade, but historically they have generally performed better. One of the oft-cited stock pricing models is the Fama French three-factor model, which found that small-cap stocks have outperformed large-cap stocks by two percentage points every year since 1927. “It’s been a tough ride for small caps. You’ve seen the ‘Big Seven’ suck all the air out of the room, both in terms of attention and investor flows into the asset class. I see Analysts have said this is the longest period of underperformance on record,” said American Century Investments’ McLeod. But Rode added, “However, over time, this is cyclical.” Rode expects this outperformance may continue for a period of time, ranging from 12 to 24 months. Teton Westwood’s Galluccio, meanwhile, thinks it could last longer. “I think small caps are going to outperform over the next three years,” Galluccio said. Boost from onshore investment But there are other reasons driving small-cap bulls. Amid heightened geopolitical tensions, the localization of overseas supply chains, particularly for semiconductor companies and pharmaceutical companies, is expected to support small-cap stocks that are typically domestically focused. Rohde cited Panasonic’s electric vehicle battery plant in DeSoto, Kan., as an example that could boost profits for smaller companies contracting for construction and road construction, as well as regional banks that help finance those projects. SUM YTD mountain Summit Materials Year-to-date Building materials company Summit Materials is one such stock that could benefit from a reshoring project. The stock is up just 2% this year. Analysts polled by London Stock Exchange Group (LSEG) think it’s a buy. Likewise, Teton Westwood’s Galluccio invested in wafer processing company Cohu, which he said is cheap, profitable, has no debt and plenty of cash on its balance sheet. “These are the types of companies we’re looking at,” he said. Cohu shares are down about 10% this year, but the stock is considered a buy based on LSEG consensus estimates. COHU’s Year-To-Year Alpine Other trends in Cohu stock that should boost small-cap stocks include a steepening yield curve and increased M&A activity. Small-cap investments are inherently risky because they are less liquid and more closely tied to the economy than large-cap investments. However, investors can try to avoid these pitfalls by investing in quality companies with strong balance sheets and high returns on capital. “The past decade has been the first time in many years that small-cap stocks have underperformed, leading talkers to say quality, quality, quality is the growth of large-cap stocks. Well, guess what? Quality can also be small-cap stocks,” added Lucio said.
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