Stocks of smaller companies have had a difficult year, with their performance paling in comparison to their larger counterparts. However, this presents an opportunity for investors as their current low valuations and potential for improvement in fundamentals make them an attractive option.

Small Cap Stocks vs Large Cap Stocks

The S&P Small Cap 600, which consists of companies with an average market capitalization of approximately $2 billion, has experienced a decline of just over 4% this year. In stark contrast, the large-cap S&P 500 has gained 14% during the same period.

This discrepancy is not surprising, considering that the S&P 500 is weighted by market capitalization. The impressive rise of tech giants in response to optimism surrounding artificial intelligence has significantly contributed to the overall growth of the benchmark index.

Challenges Faced by Smaller Companies

Smaller companies face unique challenges in comparison to their larger counterparts, especially when it comes to handling higher interest rates. Since the Federal Reserve began increasing borrowing costs in March 2022, interest rates have become a dominant factor in the economic landscape. Unlike bigger businesses, smaller companies find it more challenging to manage costs and protect profit margins when higher rates impede sales growth by restricting demand for goods and services.

Earnings have been a major concern for small-cap stocks. Analysts predict a nearly 1% decline in aggregate sales for the S&P 600 this year, compared to the previous year, according to FactSet. As a result, earnings per share are expected to drop by 14% due to shrinking profit margins.

Looking Ahead

While a rebound in sales and profits is anticipated for 2024, forecasts for the upcoming year still fall significantly short. The FactSet consensus estimate for aggregate 2024 earnings per share of companies listed in the S&P 600 is currently 17% lower than at the beginning of this year.

The Worst May Be Over for Small-Cap Companies

Good news for small-cap companies: The data suggests that the worst may be behind us.

According to Morgan Stanley, analysts have already revised down their forecasts for the 2024 EPS of the majority of S&P 600 companies. This trend of downward revisions has reached its peak, excluding the exceptional reductions caused by the arrival of Covid-19 in early 2020. In fact, the ratio of cut forecasts to increased forecasts is currently at its highest level in the past decade.

However, this pessimistic outlook actually works to the advantage of small-cap companies. They now have a greater opportunity to exceed bottom-line expectations, particularly if the economy manages to avoid recession and the Federal Reserve reduces interest rates to stimulate growth.

So, keep an eye out for the beginning of a rally. As Lori Calvasina, chief U.S. equity strategist at RBC, stated on Monday, small-cap stocks tend to bottom out in performance 3-6 months before EPS forecasts start to rise again.

In terms of valuations, there is still plenty of upside potential for the S&P 600 as long as profit expectations improve. Currently, the index is trading at approximately 12 times expected EPS for the next 12 months. This represents a 34% discount compared to the S&P 500, which trades at a multiple of 18.2 times.

The significant valuation gap between the two indices signals that small-caps are deserving of attention. When smaller companies are in favor, the S&P 600 can catch up to the valuations seen in the S&P 500.

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