The fourth-quarter market rally lifted most boats, but the headliner was not the S&P 500 or large-cap stocks; it was small caps.
Small-cap stocks, as measured by the Russell 2000, jumped 13.6% in the fourth quarter, outpacing the S&P 500, which was up 11.2%. In the last two months of the year, the Russell 2000 jumped 22%. The surge basically salvaged what had been a subpar year for small caps, as they had been in the red year to date heading into Q4, well off the pace of large caps. Ultimately, the rally resulted in a 15% gain for the Russell 2000 in 2023.
Will the rally continue in 2024? In its 2024 outlook, Goldman Sachs Group (NYSE:GS) projects a 15% return for the Russell 2000 this year, compared to 7% for the S&P 500. Some leading small-cap portfolio managers are also bullish on small-cap stocks in 2024.
Out of the wilderness
One of the leading small-cap specialists, Royce Investment Partners, sees the momentum from Q4 continuing this year. In fact, in his outlook for 2024, Francis Gannon, co-chief investment officer at Royce, outlined a significant runway for small caps.
“Against the backdrop of moderating inflation, normalized interest rates, and a still-growing U.S. economy, it looks to us that small-cap’s [sic] lengthy stretch in the relative performance wilderness has run its course,” Gannon wrote in his January commentary. “Our reasoning is rooted in the notion that as the economy continues to stabilize, valuations are likely to rise for those businesses that have largely sat out the mega-cap performance regime. Such a move is likely to benefit small caps more than larger companies. And large-cap cycles have historically peaked at market tops crowded with mega caps.”
Gannon expects a broadening of large-cap returns, well beyond the so-called “Magnificent Seven.” Historically, when that happens and the equal-weighted Russell 1000 outperforms the cap-weighted Russell 1000, the Russell 2000 tends to outperform large caps over most one-, three-, and five-year rolling periods dating back to 1984, Gannon said, citing company research.
One area of the small-cap universe that could see growth is regional banks, according to Miles Lewis, who manages the Royce Small Cap Total Return fund. As interest rates start to come down, net interest margins should start to expand, and loan growth should improve.
“Since the market’s recent bottom in late October, small-cap banks have meaningfully outperformed the broader small cap indexes,” Lewis wrote in December. “Importantly, this was not the case coming out of either the 2008-09 Financial Crisis or COVID-driven market bottoms. This subtle, yet important shift in the dynamics of the small-cap market suggests that banks are poised for a strong run in 2024, one that’s rooted in improving fundamentals, poor stock performance in 2023, and attractive valuations.”
What to look for in small caps
Of course, finding the right small-cap stocks is where the rubber meets the road, and that’s not easy, as a significant percentage of small companies are not profitable. In a recent commentary, hedge fund managers at Polen Capital shared what they look for in small caps.
One of Polen Capital’s keys is to look for stocks with a competitive advantage in their space. This is not always easy to find with smaller companies, and it takes some research. However, one metric that is often indicative of a competitive edge is high or improving gross margins.
“We believe this metric not only captures a potentially advantaged business but also enables the company to re-invest in the business through research & development, sales & marketing, or capital expenditures that can potentially lead to greater long-term value creation,” Polen Capital managers wrote in their December commentary.
Another key metric is free cash flow, which is the cash generated by the business after expenses and capital expenditures. High free cash flow means the company has the financial flexibility to navigate downturns and the capital to reinvest in its growth.
Polen Capital managers also key in on cash flow return on invested capital (CFROIC), which gauges how a company makes money on invested capital.
“High CFROIC can signal a few things, not least of which is a management team that is effective at allocating capital. In a sense, it’s a scorecard that reflects strategic decisions over time aimed at maximizing shareholder value,” they wrote.
Thus, while small caps in general may see a resurgence in 2024, there remains the potential for significant volatility with small, growing companies, and these metrics may be helpful in finding the right opportunities.
