Will small caps lead in 2024?

The fourth quarter market rally lifted most boats, but the headliners weren’t the S&P 500 or large-cap stocks. It was small caps.

Small-cap stocks, as measured by the Russell 2000, rose 13.6% in the fourth quarter, outpacing the S&P 500, which rose 11.2%. In the last two months of the year, the Russell 2000 index is up 22%. The surge basically rescued what had been a poor year for small-cap stocks. That’s because they were in a loss year heading into the fourth quarter, well behind the pace of large-cap stocks. Ultimately, this rally pushed the Russell 2000 up 15% in 2023.

Will the protests continue in 2024? In its 2024 outlook, Goldman Sachs Group (NYSE:GS) expects the Russell 2000 to return 15% this year, while the S&P 500 expects to return 7%. Some leading small-cap portfolio managers are also bullish on small-cap stocks. 2024.

in the wilderness

Royce Investment Partners, one of the leading small-cap experts, sees momentum continuing in the fourth quarter of this year. In fact, Francis Gannon, Royce’s co-chief investment officer, outlined significant runway for small-cap stocks in his 2024 outlook.

“Against a backdrop of easing inflation, normalizing interest rates, and continued growth in the U.S. economy, small-cap stocks appear to have long remained at the margins of their relative performance,” Gannon wrote in a January commentary. . “Our reasoning is rooted in the notion that valuations of companies with large performance regimes are likely to rise as the economy continues to stabilize. This move is likely to benefit small caps more than larger companies. And the large-cap cycle has historically peaked at the top of a market full of large-cap stocks.”

Gannon expects large-cap returns to expand well beyond the so-called “Magnificent Seven.” Historically, when that has happened and the equally-weighted Russell 1000 has outperformed the market-cap-weighted Russell 1000, the Russell 2000 has tended to outperform large-cap stocks in most one-, three- and five-year rolling periods since 1984, Gannon said. said: Citing company research.

One small-cap sector that could grow is regional banks, according to Miles Lewis, who manages the Royce Small Cap Total Return fund. As interest rates begin to fall, net interest margins will expand and loan growth will also improve.

“Small banks have significantly outperformed the broader small-cap index since the market recently bottomed in late October,” Lewis wrote in December. “The important thing is that this is not a case of the 2008-09 financial crisis or the market bottom caused by COVID. “Subtle but significant changes in small-cap market dynamics suggest banks are poised for strong growth in 2024, rooted in improving fundamentals, weak 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 encouraging road meets, and it’s not easy because a significant number of small companies are unprofitable. In a recent commentary, hedge fund managers at Polen Capital shared what they are looking for in small cap stocks.

One of Polen Capital’s keys is finding stocks with competitive advantages in their sectors. This isn’t always easy to find in smaller companies and requires a bit of research. However, one indicator of competitive advantage is high or improving gross margins.

“We believe that this metric not only captures potentially profitable businesses, but also allows companies to reinvest in their businesses through research and development, sales and marketing, or capital expenditures, which could potentially lead to greater long-term value creation,” Polen said. says: Capital managers wrote in a December commentary:

Another key metric is Free Cash Flow. This is the cash generated by the business after costs and capital expenditures. High free cash flow means the company has the financial flexibility to weather economic downturns and the capital to reinvest in growth.

Polen Capital managers also focus on cash flow return on invested capital (CFROIC), which measures how a company makes money on its invested capital.

“High CFROIC can send several signals, not least of which is that you have a management team that is effective at allocating capital. “In a sense, it is a scorecard that reflects strategic decisions over time with the goal of maximizing shareholder value,” they wrote.

So, while small businesses in general could see a resurgence in 2024, there is still potential for significant volatility for growing small businesses and these indicators can help you find the right opportunities.