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Small-Cap Stocks: The Top 4 Picks to Exploit the Market Shift Post-Magnificent 7

Hannah Perry | October 14, 2024

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Small-Cap Stocks Can Fill the Mag 7 Market Void: 4 to Play

The reign of the Magnificent 7 stocks—the massive technology firms that spurred market gains for much of the previous year and into this one—appears to be waning, with their recent performance showing signs of mediocrity. Investors are left questioning whether the gains that were realized would spur rejuvenation in other sectors to sustain overall index health, or if a total market deflation would be required to identify new growth catalysts.

Mark Sherlock, who manages a U.S. small and mid-cap fund at Federated Hermes in London, highlights a significant issue: most large-cap stocks are currently overshadowed by exceedingly high expectations regarding future earnings. Interestingly, this situation presents a unique opportunity for savvy investors. According to Sherlock, the strongest potential for gains resides in small-cap stocks within the S&P 500 and below, as they are less burdened by inflated expectations.

While it’s natural to consider his perspective as self-serving—given that his small and medium-size fund benchmarks against the Russell 2500—Sherlock’s SMID fund boasts an annualized net return of 15% since its inception in 2009. While this figure doesn’t quite measure up to the S&P 500, powered largely by the Magnificent 7, which achieved annual gains exceeding 20% in recent years, three crucial reasons support his claim that small-cap stocks will outperform in the coming years.

1. Undervalued Smaller Companies vs. Richly Valued Larger Caps

The first reason for the potential outperformance of small and mid-cap stocks is the current market valuation landscape. Large-cap stocks are highly valued, which creates pressure to meet elevated growth expectations. Conversely, smaller companies may be undervalued after struggling during recent years. Some sectors, such as real estate, have already endured recession-like conditions resulting from the Federal Reserve’s interest rate hikes.

2. Economic Exposure

The second reason lies in the exposure small-cap firms have to the domestic economy. Smaller companies tend to generate their revenue from domestic sales, as opposed to larger firms, which often depend heavily on international market sales. For investors with a bullish outlook on the U.S. economy, small-caps present a compelling opportunity.

3. Mergers and Acquisitions Surge

Lastly, Sherlock points to potential surges in mergers and acquisitions fueled by attractive valuations within the small-cap sector. With many smaller firms looking well-positioned for growth opportunity, strategic buyouts by larger firms could invigorate value in this space.

Election Risk and Market Stability

Interestingly, these outlooks remain relatively insulated from the electoral outcomes of the upcoming November elections, which are likely to generate a divided government. Historically, gridlock in Washington tends to create a stable environment that markets favor. As Sherlock aptly puts it, “The U.S. is an economic juggernaut that keeps on chugging,” implying that the economy itself could become the ultimate winner of the election.

SMID Stocks to Watch

Focusing on companies with solid cash flows and robust competitive barriers, Sherlock takes a long-term investment approach. His preference lies in holding investments for around five years, embodying a “tortoise beats the hare” strategy that provides reliable exposure to the U.S. economy.

1. Power Integrations

In the semiconductor sector, not all players are giants like Nvidia and Intel. Smaller firms can carve niche markets, such as Power Integrations, which specializes in high-voltage power conversion units for city lights and electric vehicles. Despite a decline from over $100 in 2021 to about $63 today, the company may be poised for a comeback as a growing number of companies prioritize energy efficiency. The market value stands at approximately $3.5 billion, trading at 38 times forward earnings. Of seven analysts on FactSet, five rate the shares as Buy, while the others rate them as Hold.

2. Martin Marietta

Another smaller cap with robust potential is Martin Marietta, which operates rock mines and produces essential materials for road construction. This Raleigh, North Carolina-based firm is part of both the S&P 500 and Russell 2500 indexes. With a workforce of 9,400, its stock has appreciated by 23% in the past 12 months, currently trading at 31 times forward earnings. A target price of $625 represents an 18% upside from the recent trading price of $530, according to analysts on FactSet.

3. Trex

The home improvement sector has faced challenges post-pandemic; however, companies such as Trex, which manufactures decking materials, may prosper as homeowners start to invest again in their properties.

4. Fortune Brands

Additionally, Fortune Brands, manufacturing home and security products from Master Lock padlocks to Moen faucets, could see a resurgence as spending on home improvement rebounds.

These stocks exemplify potential value within the smaller-cap realm. As the stock market seeks to diversify away from its concentration in the biggest names, investors hunting for opportunities without extraordinary earnings growth already priced in may find promising prospects in small-cap companies.