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Discover Winning Small-Cap Stocks Amid Fed Rate Cuts: Expert Strategies for Investors

Hannah Perry | October 8, 2024

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Small-Cap Stocks Rally After Fed Rate Cuts Begin: Strategies for Finding Winners

The recent shift in U.S. monetary policy, marked by the Federal Reserve’s initiation of rate cuts, has sparked renewed interest in small-cap stocks. This segment of the market often thrives in environments of reduced borrowing costs, as small companies tend to possess more variable-rate debt compared to their larger counterparts. As the economy picks up steam alongside easier monetary policy, small-cap firms can expect significant growth opportunities.

With small-cap stocks logging impressive performances during past rate-cut cycles, investors are keen to uncover potential champions in this space. Notably, recent market data highlights that the Russell 2000 index trades at a price-to-earnings (P/E) ratio of just 0.74 times that of the larger-cap Russell 1000 index, suggesting a substantial downside for gains over the next decade. Bank of America quant strategist Jill Carey Hall indicates that this discrepancy points to an expected 9% annualized return for the Russell 2000 versus a modest 2% annualized return for the Russell 1000. Yet, while enticing, investing in small caps entails its own complexities.

Mick Rasmussen’s Insights on Small-Cap Investing

Mick Rasmussen, manager of the Wasatch Long/Short Alpha Fund, has emerged as a notable figure in the small-cap investment landscape, with his fund returning a remarkable 32.5% over the past year compared to 17.2% from peers and a benchmark index return of 29%. As the fund has surged by approximately 51% in the last three years, Rasmussen shares invaluable advice for investors looking to tap into the potential of small-cap stocks.

1. Focus on Quality Management

Rasmussen emphasizes that the caliber of management is a critical factor in the success of small-cap companies. According to him, “With small caps, management is a much bigger differentiator than at large caps.” Investors should be on the lookout for consistency in messaging and proven track records of delivering on promises. Through thorough research methods, which might include attending earnings calls and reviewing management performance across various market conditions, investors can gain insights into company management’s effectiveness. A prime example of strong management is the Ensign Group (ENSG), which excels at managing skilled nursing facilities and demonstrates substantial value creation through disciplined capital deployment.

2. Seek Long-Term Growth Opportunities

Identifying long-term growth potentials that may be overlooked by the market is another essential strategy. As Rasmussen points out, “If a company can produce double-digit earnings growth for 10 years, you can pay a high multiple.” Finding companies with strong cash flow that can sustain their growth trajectory is key. UFP Technologies (UFPT) exemplifies this approach by manufacturing components used in advanced medical equipment, both diversifying its customer base and funding further expansion through cash flow. Another solid candidate in Rasmussen’s portfolio is Novanta (NOVT), which aims for a 15% annual earnings growth rate over the next decade by venturing into new product lines.

3. Prioritize Companies with Significant Inside Ownership

Rasmussen advocates for investing in small-cap firms where management holds substantial equity stakes, indicating a vested interest in their performance. Companies like Paylocity Holding (PCTY) and XPEL (XPEL) each have insiders owning over 20% of their stocks, promoting accountability and alignment of interests between management and shareholders.

4. Embrace Winning Stocks

Additionally, Rasmussen emphasizes the importance of recognizing successful investments and allowing them to continue growing. Instead of hastily cashing out on initial gains, it’s better to evaluate ongoing improvements in cash flow and margins as reasons to maintain or even increase positions in winning stocks. An illustrative example is Guidewire Software (GWRE), which supports the insurance industry’s critical transition to cloud-based solutions—a trend poised for substantial growth as companies integrate advanced technologies like AI.

Conclusion

For those considering an investment in small-cap stocks, the insights shared by Mick Rasmussen paint a compelling picture of how these companies can thrive in a favorable economic backdrop fostered by rate cuts. By focusing on quality management, long-term growth prospects, insider ownership, and maintaining confidence in winning positions, investors can navigate this dynamic investment space with greater assurance.

As small-cap stocks rally in response to the Fed’s rate adjustments, prudent investors are encouraged to look for companies with robust growth fundamentals and a proven commitment from management to maximize returns in the coming years.