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By David Barr

Taylor Swift recently won her 14th Grammy award and her Eras Tour surpassed the US$1-billion mark with more than four million tickets sold across 60 dates.

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Today, it’s hard to imagine that Swift’s career in 2016 was on the skids. Yet by 2017, with the release of her album Reputation, she had become resilient, mature and a formidable performer on her own terms.

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I hope Swifties will forgive me, but her career reminds me of what has been happening with small-cap stocks: short-term troubles giving way to very positive outcomes.

Contrary to popular opinion, I see green shoots in the small-cap space due to four catalysts that have the potential to create a three-to-five-year period of outperformance.

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Cruel Summer

Last year was not a banner year for small-cap stocks. The one-two punch of higher interest rates and recession fears drove investors to the perceived safety of cash and the big names such as the Magnificent Seven. Typically, smaller companies do not have the same access to capital raising as larger companies do, making them more sensitive to economic cycles and rising borrowing costs.

The start of 2024 has also been challenging, with the Russell 2000 index of small- and mid-size companies lagging the S&P 500 by the widest gap since 1997. But a slow start is not a deal breaker: since 1979 (excluding the great financial crisis in 2008), the Russell 2000‘s median performance has been a gain 26.1 per cent in six of the seven times the index has declined at the start of the year by at least four per cent.

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You Need to Calm Down

As Howard Marks states in his classic book Mastering the Market Cycle: Getting the Odds on Your Side, investors need to understand where we are in the market cycle, in addition to their psychological and emotional states and their concomitant behaviours.

Small-cap stocks have endured a long winter of investor disinterest. This doom loop is evidenced by articles with headlines such as Death of Small Cap Equities. Negative magazine cover stories can be viewed as contrarian signals. The phenomenon even has a name: Magazine Cover Indicator. The most famous example is the 1979 BusinessWeek cover story, The Death of Equities, which marked the start of a two-decade bull market.

The time when most investors are fearful or have already capitulated, often proves to be an excellent time to buy at bargain prices. Investors’ tendency to exaggerate both good and bad news can present attractive buying and selling opportunities.

Shake it Off

Investors have finally noticed that small-cap stocks are cheap on both a relative and absolute basis. They are cheap relative to both their 10-year average and to the large-cap index. The setup for quality small caps has not been this attractive in a very long time.

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For the first time since June 2021, more fund managers expect large caps will gain less than small caps this year, marking an inflection point, according to the latest Bank of America Corp. Global Fund Manager Survey.

As interest rates stabilize and potentially drift lower, smaller companies are likely to benefit the most and their wide valuation discounts will shrink. As there is a wide dispersion of quality in small-cap indexes, bottom-up, prudent stock selection in the small-cap space is key to finding those beaten-down gems with the potential to become multi-baggers.

Ready for it

What will drive small-cap outperformance in 2024? Earnings will be in the spotlight and are expected to rebound this year. An important trend to watch is that some of the most promising young companies are choosing to stay private for longer, assuming they have the financial backing.

One outcome of this is that small-cap indexes, such as Russell 2000, now hold a higher number of unprofitable companies. Companies that generate free cash flow, and have strong balance sheets, a large total addressable market and capable management teams will become even more attractive within this universe and are (finally) poised for a re-rating.

David Barr is chief executive of PenderFund Capital Management Ltd.

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