UBS Group joins chorus of Wall Street analysts recommending small-cap stocks

On Tuesday, a team of market strategists at UBS Group became the latest to recommend that clients consider adding exposure to small caps on the expectation that the torrid rally seen by the Russell 2000 during the fourth quarter could soon restart. But investors who want to take advantage of these potential gains need to act fast, the team added.

See: Small-cap stocks had a rough start to 2024 — but could shine the rest of this year, says stock market’s biggest bull

See: Small-caps continue to lag. That may be good news for the overall stock market.

To be sure, the UBS analysts acknowledged that small-cap stocks have certain disadvantages, including weaker balance sheets. And they are typically more sensitive to the economic cycle, while their shares are less liquid than their large-cap peers.

But the UBS team also highlighted certain features that could make them more attractive in this market, including more compelling opportunities for earnings growth once the Fed starts cutting interest rates. The UBS team forecasts double-digit earnings growth for companies in the S&P 600
SML
small-cap index. This would mark a substantial improvement over the 10% aggregate earnings decline from 2023.

Relatively attractive valuations are also likely to work in small caps’ favor, the analysts said. The Russell 2000 is presently trading at a roughly 55%
discount to the Russell 1000
RUI,
compared with a 10-year average discount of 32%.

Also, intrepid investors who are willing to take a risk on small caps could benefit from increased market inefficiencies in the space, since small caps aren’t as widely covered by analysts,

“There can be bigger payoffs to stock selection in smaller-cap indexes compared to large caps due to a higher dispersion in performance. Since most companies are less followed by the analyst community, there can be greater inefficiencies that can be exploited. As a result, there is greater scope for active managers to achieve above-market returns (alpha) in this part of the equity market,” the UBS analysts said in a their note.

Finally, small caps can add a layer of diversification to investors’ portfolios, the team said. According to UBS’s numbers, the correlation of U.S. small and mid-caps to the MSCI World index is around 0.52. A correlation of 1 means two assets move in lockstep, while a correlation of 0 means they’re completely uncorrelated.

“Smaller stocks move less in lockstep with developed market equities, given a correlation of around 0.6 for large caps in both regions to MSCI World. While this is modest, we think the difference is meaningful from a portfolio diversification standpoint,” the UBS team said.

So, while small-cap stocks tend to see more cyclical swings, the UBS team believes U.S. and European small caps, along with Swiss mid-cap stocks, would be among the biggest beneficiaries in a scenario where U.S. economic growth remains robust, inflation continues to slow and the Fed moves ahead with preemptive interest-rate cuts.

The Russell 2000
RUT
is down 0.8% since the beginning of January, following a rally of 13.5% during the fourth quarter, according to FactSet data. By comparison, the FANG+ index, which tracks the performance of the 10 largest megacap technology companies trading in the U.S., is up 7.4% in January. Returns for these two indexes came in at 96%, for FANG+, and 15.1% for the Russell 2000, during 2023.

Small caps looked set to open higher early Tuesday, thanks to strong gains from the Russell 2000’s most heavily-weighted stock, Super Micro Computer Inc.
SMCI,
+4.54%

By comparison, the S&P 500
SPX
has gained 3.3% since the start of the year, on top of a 24.2% increase in 2023, excluding dividends. The Nasdaq Composite
COMP,
meanwhile, has gained 4.1% since Jan. 1, following a gain of 43.4% in 2023. The Dow Jones Industrial Average
DJIA
gained 13.7% last year, and is up 1.7% in 2024.