Small-Caps Are Fading: A Closer Look at Promising Stocks

Introduction

In the often unpredictable landscape of financial markets, small-cap stocks have experienced a significant surge, drawing attention from savvy investors. The S&P 600 index, which boasts an average market capitalization of around $3 billion, has seen a remarkable 16% increase this year. Following the November elections, the index reached an impressive record close at 1544—signifying a great deal of optimism among investors, particularly in light of President-elect Donald Trump’s fiscal policies. However, the question looms large: can this uplifting trend sustain itself?

The Driver Behind Small-Cap Growth

President Trump’s administration has been characterized by ambitious proposals for increased fiscal spending that could inject tens of billions of dollars per year into the economy. This would naturally benefit small-cap stocks, which are less reliant on technology and more anchored in sensitive economic sectors like financials and consumer discretionary. Additionally, the promise of tax cuts for domestic production significantly enhances the earnings potential for this index, positioning it favorably when compared to the globally-exposed S&P 500.

Despite these favorable conditions, a troubling sign is emerging. The current price level of the S&P 600, just below 1510, suggests that most of these positive factors have already been priced into the market. Notably, the index has not experienced a new high in weeks, indicating that the buying spree may be tapering off. According to Bank of America, investors have poured a record $30 billion into U.S. small-cap funds this year, tripling last year’s inflow. However, historical patterns show that record inflows into small-caps are typically followed by net outflows, and projections may be overinflated.

The Crucial “Show Me” Moment

Leading market analysts, including Dennis DeBusschere of 22V Research, indicate that without a clear catalyst for further growth, small-cap stocks may struggle to sustain their momentum. The S&P 600 is currently priced at 17 times the anticipated earnings for 2025, a notable increase from just over 14 times at the beginning of this year. While this valuation is still lower than the 22 times seen in the S&P 500, the narrowing gap suggests a precarious position for small-cap investors. If firms fail to deliver on earnings, disappointment may trigger a decline, showcasing that the stakes are high, and the pressure is palpable.

Identifying Promising Stocks

With such uncertainty looming, it becomes crucial for savvy investors to identify which small-cap stocks are positioned to thrive despite this climate. Barron’s conducted a thorough screening of S&P 600 companies, focusing on those that have consistently met or exceeded analyst earnings estimates—a critical marker for success. The screening criteria also included firms expected to achieve at least 10% earnings growth for both 2025 and 2026 while maintaining favorable price-to-earnings ratios.

Among the 23 stocks that surfaced from this screening, several stand out for their sustained performance and growth prospects:

• Enova International: This online lender, valued at $2.7 billion, continues to exhibit robust performance.
• Allegiant Travel: Worth $1.5 billion, this travel company has demonstrated resilience in the current market climate.
• LiveRamp Holdings: With a $2.1 billion market cap, this software-as-a-service provider is a significant contributor to the sector.
• Mr. Cooper Group: This mortgage servicing company is valued at $6.2 billion and is poised for continued success.
• Steven Madden: This fashion brand ranks at $3.2 billion and has a strong international growth strategy.
• Tripadvisor: Valued at $2 billion, this company continues to thrive in the competitive travel sector.

Conclusion

While the small-cap sector has experienced notable growth, current conditions suggest that a careful selection process is paramount. Investors must conduct their due diligence, scrutinizing the underlying fundamentals of these stocks. The emerging narrative is one of caution: without robust earnings growth, small-cap investors may find themselves at the mercy of market shifts. As traditional financial principles advocate, ensuring a solid foundation for investment decisions will serve as a critical safeguard in today’s tumultuous economic climate.

In the final analysis, while small-cap stocks have had their moment in the spotlight, the time to reevaluate their long-term viability has arrived. Keep a watchful eye on earnings reports and market trends, for they will dictate the fate of these dynamic equities moving forward.