A broadening of markets will be positive for small-cap stocks

After years in the shadow of mega-cap tech names, small-cap stocks are poised for a surge in value, says Francis Gannon, co-chief investment officer and managing director at Royce Investment Partners.

He said small cap is a “forgotten asset class” that represents great opportunity in the current moment.

“They are one of the last inefficient asset classes out there,” he said on the latest episode of the Soundbites podcast.

Gannon said history has shown that after times of great market concentration — on the “Nifty 50” in the 1970s, or on tech names during the tech bubble of 1995 — markets eventually broaden out, leading to a relative outperformance by small-cap over large-cap stocks.

“I think we’re at that same moment in time today,” he said. “We’re on the cusp of what could be a regime change. And we know that small-cap cycles — when they start — they last for more than a decade.”

He said the tide is already turning. The third quarter of 2024 was the first since  Q4 2023 when small caps outperformed. And he said since the U.S. election, small caps have really picked up.

“If you look at the one-year numbers now for the Russell 2000, I think it’s surprising for people to see that the Russell 2000 is outperforming the Russell 1000, the S&P500 and even the NASDAQ, post the U.S. election,” he said.

He acknowledged that small-cap earnings have been strained in recent months, but there are reasons to believe that will change.

“When you have these lower-return periods and small caps are out of favour, the next several years tend to be quite strong,” he said.

Earnings were lower because, following the asset class’s peak as measured by the Russell 2000 on Nov. 8, 2021, it began pricing in a potential recession — one that never materialized. Small caps declined 32% into the lows of June 2022.

“We have been fighting out of that moment since then,” he said. “I think that’s been problematic for the asset class. But I do see that changing as you get into the fourth quarter of this year and into 2025.”

He said the class will benefit from deglobalization trends, as well as resurging re-industrialization in the U.S.

“I think these are two major trends that are really going to benefit a lot of small-cap companies,” he said.

The current falling-rate environment should also benefit small caps, given that 40% of the debt in the Russell 2000 is floating-rate debt.

“Anytime you see the Fed cut rates, it will help those companies that have floating-rate debt,” he said.

In the small-cap space, he particularly likes Katy, Tex.-based Academy Sports + Outdoors, which has a $3.5 billion market capitalization.

“It is the second largest sporting goods retailer in the United States, with about 290 stores and growing, predominantly in the southeast, but we think it’s going to continue to grow,” he said. “It’s just been a wonderful opportunity for us to buy what we think is a very high-quality retailer at what has been a really good price. So, we expect good things from them going forward.”

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This article is part of the Soundbites program, sponsored by Canada Life. The article was written without sponsor input.