Relative Underperformance of Small Cap Stocks Opens Up Opportunities, Including These 10 Ideas

Last year marked a tumultuous period for small-cap stocks, with the MSCI USA Small Cap Index enduring a substantial setback, dropping by 17% over the year. The turbulence didn’t end there, as small-cap stock index returns continued to diverge from broader U.S. market index trends in 2023, posting a mere 0.7% to the end of May vs the MSCI USA index which has risen around 10% over the same period.

Despite this trend, a beacon of optimism is beginning to emerge within the financial industry, as some analysts predict that small-cap stocks could soon outshine their large-cap counterparts.

While larger corporations often dominate the headlines and capture investor attention with their size and market influence, it’s essential not to underestimate the potential of small-cap companies.

More Nimble

Small caps can usually be more nimble in times of market volatility and economic uncertainty, enabling smaller firms to rapidly change their operational strategies, such as where they source goods and materials, helping them control costs and maintain profitability.

For instance, consider the case of a small-cap firm operating in the specific sector of environmentally friendly packaging. Amid global supply chain disruptions, this hypothetical company might swiftly shift its sourcing strategy, opting for local suppliers over overseas ones. This strategic shift could help the company reduce its costs, ensure supply continuity, and potentially increase its market appeal by emphasizing its local sourcing and reduced carbon footprint.

Amid the current market turbulence, it’s this very agility and resilience that is fueling optimism among some analysts. They believe that the underperformance of small-cap stocks in the recent past has led to their relative undervaluation, setting the stage for potential growth.

In other words, the current low price of these stocks might represent significant buying opportunities for discerning investors willing to take on the inherent risk of investing in smaller companies.

Fintel’s Small Cap Value Model Portfolio

The Fintel platform’s model portfolio for small-cap value stocks was created by combining the holdings of funds with similar investing strategies and identifying the stocks that are the most widely held among the funds. The model can help identify some of these stocks worth potentially investing in.

Some of the stocks currently flashing on this list include:

Columbia Banking System (US:COLB), which has seen four new funds purchase the stock during the quarter and a 51% rise in the number of shares held by institutions.

Seacoast Banking Corporation of Florida (US:SBCF) also gained four new funds on the register during the quarter as the number of shares held by institutions doubled.

We found two funds buying into ChampionX (US:CHX) despite the total number of shares held by institutions slightly falling during the quarter.

Another bank on the dashboard was Cadence Bank (US:CADE), which had two funds buying shares during the quarter.

Integer Corp (US:ITGR) attracted two new funds, driving the total number of shares held by institutions higher by 4%.

While the past couple of years have been challenging for small-cap stocks, the market conditions could be setting the stage for a potential revival when the Federal Reserve finishes its rate hiking cycle and the market resets.

The ability of these smaller companies to quickly adapt and respond to changing conditions, combined with their current low valuations, might just pave the way for a small-cap resurgence.

Supported by Trends

Other notable stocks that we found showed buying activity from at least two hedge funds during the quarter include: Mativ (US:MATV), Papa John’s International (US:PZZA), Sensient Technologies (US:SXT), FormFactor (US:FORM) and ASGN Inc (US:ASGN).

This prediction of a small-cap revival isn’t baseless optimism; historical trends support this view. Market data often shows a pattern where small-cap stocks start outperforming large caps shortly after the beginning of a recession or market downturn.

This outperformance is due to market mechanisms pricing in an economic recovery before it materializes, providing an advantageous window for investors who are attuned to this trend.

Patience will be key for investors, as the predicted resurgence of small-cap stocks is expected to occur over the next three to five years.

The potential payoff, however, could be significant. Companies that survive and grow during these challenging times can offer substantial returns to their investors as the economy recovers and expands.

This article originally appeared on Fintel