Is the Outlook Improving for Global Small-Caps?

After a long stretch of outperformance by large-cap stocks, there was a notable rotation toward small-caps in July. However, after the volatility of early August, investors may ask whether the pieces are in place to sustain small-caps through the rest of the year and into 2025.

As we look ahead, we see reasons to be optimistic.

Small-Cap Stocks and Interest Rates: Potential Tailwinds Ahead

Global small-cap stocks have borne the brunt of worries about inflation, rising interest rates and slowing economic growth over the last three years. As shown in Figure 1, the sharp rise in rates starting in 2022 helped drive a rotation out of small-caps into large-caps. Small-cap growth stocks were particularly hard hit.

Though economic uncertainty remains, inflation is headed in the right direction, and central banks worldwide have begun cutting rates, with the Federal Reserve (Fed) poised to join them in September.

The Fed’s approach has been more cautious than many expected coming into the year. However, with rates trending lower, investors could benefit from an environment of moderate economic growth and declining inflation, which we believe would be conducive to risk-taking and a tailwind for small-caps.

Such a shift could enable investors to shift their focus from central bank policy to corporate profits, creating a more favorable environment for active security selection. Longer term, we believe investors will reward companies with improving earnings growth.

Market Performance Trends May Benefit Small-Cap Stocks

The market’s largest stocks, the Magnificent 7, have delivered outsized earnings growth for over a year. Indeed, NVIDIA and the other Mag 7 stocks accounted for 100% of the S&P 500^® Index’s earnings growth from mid-2023 through the first quarter of 2024.¹

Estimates from Wall Street analysts show us that the earnings growth tide may turn in the second half of 2024. According to forecasts, the rest of the market will gain ground through the fall and overtake the Mag 7 in the fourth quarter.

Taking a broader view of earnings growth, small-caps are expected to hold their own for the full year in 2024 and grow faster than large-caps in all regions in 2025. See Figure 2.²

Small-Cap Valuations Remain Compelling

Despite posting strong absolute and relative returns in July, small-caps are still attractively priced compared to their long-term average and large-caps, as shown in Figure 3. We believe the combination of discounted valuations and expectations for faster earnings per growth bodes well for the asset class.

We also believe these valuations make this an attractive entry point for those seeking to invest in small-caps to offset the concentration risk in portfolios that are overweight in large-cap stocks.

Trends Driving Profit Growth

1. Nearshoring Trends

Large-cap companies were the primary beneficiaries of globalizing supply chains. The trend is shifting, as many companies are moving manufacturing operations closer to home to mitigate the risks associated with long, complex supply chains.

Nearshoring has tended to benefit more domestically focused small-cap companies, including Stantec, a global leader providing sustainable engineering and design services. The company plans and designs factories and infrastructure projects and has benefited from growing investment in data centers, infrastructure and electric vehicle battery facilities. Stantec’s backlog has expanded, its profitability has improved and acquisitions have further supported growth.

2. Health Care Innovations

Natera is a company offering novel diagnostics in oncology, women’s health and organ health. With its established prenatal tests and emerging oncology screenings, Natera is experiencing robust demand. The company has also seen expanding insurance coverage, supported by the increasing recognition from doctors and payers of their tests' clinical utility.

Similarly, ADMA Biologics, specializing in plasma protein therapeutics for immunocompromised patients, has shown promising growth. ADMA has delivered better-than-expected revenues for 10 consecutive quarters through new product launches and expanded manufacturing capacity.

3. Maintaining an Aging Aircraft Fleet

Production backlogs at Boeing and Airbus are creating opportunities throughout the supply chain for maintaining aircraft already in service. We think the slower pace of production for new planes will likely keep older planes in service longer and lead to strong demand for aftermarket parts and services.

The trend could persist for the next few years. As a result, we expect airlines to delay the retirement of older aircraft and instead invest in maintaining them rather than phasing them out. We think this scenario could potentially translate into significant revenue growth in the aftermarket segment.

4. AI and Data Center Growth

Microsoft and Nvidia may dominate the headlines, but small-cap companies are also reaping the benefits of AI-driven growth. Examples include semiconductor testing and measurement firms like Nova and Onto Innovation. The increasingly complex semiconductor manufacturing process is fueling growth for both companies, with AI playing a significant role in driving this demand.

Not all AI beneficiaries are in the information technology sector. For example, Modine Manufacturing is classified as a consumer discretionary company. However, the recently restructured business is an industrial company that provides cooling solutions for data centers and commercial electric vehicles. Data centers are its fastest-growing end market.

Balancing Risks and Opportunities in Small-Caps

Though we are maintaining our constructive view of global small-caps, we are also aware that geopolitical, recessionary and inflationary risks remain. We are focused on identifying companies with accelerating and sustainable growth and taking a balanced approach to risks and opportunities. We also take advantage of market volatility to add to or purchase quality companies with accelerating and sustainable growth.