Small-cap stocks have faced challenges throughout this year, but there are positive signs on the horizon for these underdogs.

Upward Earnings Revisions

According to RBC Capital Markets, one positive factor for small-caps is the upward revisions in earnings. Lori Calvasina, head of U.S. equity strategy at RBC Capital Markets, states in a research note that small-caps are now benefiting from the recovery in earnings sentiment since August. September has seen a rate of upward EPS estimate revisions above 50% for the Russell 2000, indicating more positive than negative revisions. This metric shows that the gap between small cap and large-cap stocks continues to narrow.

RBC maintains its recommendation of overweighting small-cap stocks. Calvasina explains that small-caps typically outperform during cutting cycles. As investors adjust their portfolios to align with their 2024 outlooks, the discussion is expected to include Fed cuts and riskier trades like small-caps.

Fed Rate Cut Expectations

Over the past 18 months, the Federal Reserve has raised its benchmark lending rate 11 times, reaching a level not seen for 22 years as it grapples with inflation persistently above its long-run target of 2%. However, economists predict that the Federal Reserve will begin cutting rates in the second quarter of next year.

Performance Comparison

Small-cap stocks have trailed behind their larger counterparts this year. Investors looking to rebalance their portfolios in favor of small-caps after a period of large-cap outperformance need to brace themselves for the volatility of this shift. The Russell 2000 index, comprising companies with smaller market capitalizations, has experienced modest gains of about 5.37% so far this year. The S&P 600 index, consisting of smaller market value companies, has shown an increase of 2.57%. In contrast, the S&P 500 index has surged 16.9% and the tech-heavy Nasdaq Composite has jumped an impressive 33%.

Potential Boost from Mergers and Acquisitions

Another potential tailwind for small-caps is a pickup in mergers and acquisitions. While there may not be many deals currently in progress, Wall Street seems to anticipate more favorable conditions for deal makers in the near future. For instance, J.M. Smucker Co., famous for its jams and jellies, recently reached an agreement to acquire Hostess for approximately $5.6 billion, or $34.25 per share.

Small-Cap Stocks Poised for Growth in Post-Pandemic Environment

With deal activity on the rise, small-cap stocks are expected to benefit greatly. Kevin Dreyer, co-CIO for value at Gabelli Funds, believes that as M&A activity rebounds, small-caps will experience disproportionate gains.

Dreyer is particularly optimistic about three stocks: Bellring Brands (BRBR), the maker of sports nutrition and PowerBar; Atlanta Braves (BATRA); and Treehouse Foods (THS), the only major publicly traded company solely focused on private-label food products.

In addition to increased deal activity, small-caps also offer attractive valuations. Bill Talbot, senior portfolio manager and head of U.S. small-cap equities at Manulife Investment Management, notes that the recent underperformance of small-caps relative to large-caps has led to the Russell 2000 index being the most affordable it has been in over two decades.

Talbot's investment team sees numerous bottom-up stock opportunities in sectors like technology, industrials, and healthcare. They are particularly bullish on the security software industry, expecting sustained revenue growth and solid margins.

In the industrials sector, Talbot cites the current investment environment as the most favorable since the 2000s. Capital spending on infrastructure and domestic manufacturing, fueled in part by recent U.S. government stimulus spending, has created opportunities for engineering and construction companies, materials providers, and manufacturers of highly engineered industrial products.

In healthcare, long-term tailwinds emerge from demographic trends associated with America's aging population.

Overall, small-cap stocks show promise in the post-pandemic era. As deal activity resumes and valuations remain attractive, investors have an opportunity to capitalize on the potential growth within this segment.