Rising Underdogs: The Unstoppable Surge of Small-Cap Stocks in 2023

The financial universe of 2023 has been dominated by tales of tech titans and the eye-watering growth of mega-cap stocks. With around ten of these giants responsible for the meteoric rise of the S&P 500® Index in H1 2023, it’s easy to think they’re the only show in town. But beneath the surface of these headline-grabbers lies an intriguing tale of smaller players – the small-cap stocks – preparing to take the lead.

Is Narrow Leadership Fading?

While mega-cap stocks had their moment in the spotlight, market analysts predict a shift. The disproportionate reliance on a handful of companies to propel the index isn’t sustainable. Instead, broader market leadership seems imminent. Enter the small-cap stocks.

The Rise of Small-Caps: An Overdue Reckoning?

Small-cap stocks, typically classified as companies boasting a market capitalization between $300 million to $2 billion, have been the underdogs, trailing their larger counterparts. However, their current valuations, offering sizable discounts relative to large-caps, make them tantalizingly attractive.

While the Russell 2000 Index remained stagnant for the initial months of 2023, it made an impressive comeback between June and mid-August, rallying over 10%. However, past feats don’t promise future triumphs.

Decoding the Small-Cap Discount

Denise Chisholm, Fidelity’s maestro of quantitative market strategy, spotlighted the stark price-to-book-value disparity between small-caps and their larger peers. Historical data reveals that whenever such a disparity emerges, small-caps typically promise double-digit returns in the subsequent year, often overshadowing large-caps.

Another compelling metric, the price-earnings ratios, paints a similar picture. When focusing only on profitable small-caps, they’re seen trading at nearly a 30% discount to large caps. This differential hasn’t been this pronounced since the 2000 tech bubble.

Shadman Riaz, at the helm of Fidelity® Stock Selector Small Cap Fund (FDSCX), echoes this sentiment. Citing a decrease in analysts’ attention towards smaller entities, Riaz identifies this oversight as a strategic advantage for discerning investors.

A Unique Investment Universe

Investing in small-caps isn’t merely a miniaturized version of large-cap investing. The former’s composition contrasts sharply from the latter. For instance, industrials loom larger, comprising over 18% of the Russell 2000. Technology, the darling of the S&P 500, plays a smaller role in the small-cap realm, contributing just 13%.

Moreover, small-cap entities lean heavily on domestic markets, with a distinct North American flavor. This home-focused approach buffers them from global turbulence, says Riaz. The trend of reshoring, or returning manufacturing stateside, is further anticipated to buoy small companies.

Fund top holdings

• Commercial Metals Co. (CMC)
• Atkore Inc. (ATKR)
• Academy Sports & Outdoors Inc. (ASO)
• Denbury Inc. (DEN)
• Brookfield Infrastructure (BIPC)
• SPX Technologies Inc. (SPXC)
• Northern Oil and Gas Inc. (NOG)
• Axcelis Technologies Inc. (ACLS)
• Advanced Energy Industries Inc. (AEIS)
• Emcor Group Inc. (EME)

Tapping into U.S. Economic Strength

The resilience of the U.S. consumer has been paramount in staving off a recession. Companies like Fox Factory (FOXF) and Patrick Industries (PATK) embody the enduring consumer habits and the nation’s robust labor market. Further, the technology-driven staffing arena offers prospects like KForce (KFRC) and ASGN (ASGN) that cater to an ever-evolving tech landscape.

Unearthing Value amid Chaos and Innovation

Despite the volatility in sectors like regional banks and commercial real estate, or the transformative nature of technologies like AI, the small-cap domain is ripe with opportunities. Names like Cadence Bank (CADE) in banking, Jones Lang LaSalle (JLL) and Cushman & Wakefield (CWK) in real estate, and several IT service companies in the AI sector stand out.

Fund top holdings

• Insight Enterprises Inc. (NSIT)
• LGI Homes Inc. (LGIH)
• First American Financial Corp. (FAF)
• Shawcor Ltd. (SAWLF)
• Enstar Group Ltd. (ESGR)
• FirstCash Holdings Inc. (FCFS)
• Jones Lang LaSalle Inc. (JLL)
• Patrick Industries Inc. (PATK)
• Performance Food Group Co. (PFGC)
• Sitio Royalties Corp. (STR)

Conclusion

The financial panorama of 2023 offers a landscape filled with lessons and intriguing shifts. While the spotlight has primarily been on the giants of the industry, the understated narrative of small-cap stocks unveils a world of untapped potential. In a time where economic landscapes are evolving, these smaller players are not just surviving; they are preparing to thrive. As the year progresses, it will be worth keeping an eye on these dynamic entities that promise value, growth, and an opportunity to diversify portfolios beyond the usual behemoths. The world of investment, after all, is not just about following the crowd, but also about recognizing untapped potential before it becomes mainstream.