Try Small Caps for Big Profit Potential

If your gut feeling is telling you that market darlings like NVIDIA stock and Microsoft stock are getting ahead of themselves, you’re in a minority but you’re not alone. Value investing is a lonely business, but it’s highly rewarding and some of the biggest rewards could come from small companies this year.

Of course, I’m not suggesting that anyone should buy every small-cap stock available right now. Sure, it’s possible to own funds that track a small-cap index like the Russell 2000. This approach will provide a measure of diversification, but you’d also expose your portfolio to some poorly performing companies.

But at least with small-cap stocks, you won’t be overexposed to a small handful of richly valued technology stocks. I’m not only referring to the NASDAQ 100, which is very heavily weighted toward NVIDIA, Microsoft, Meta Platforms, and a few others.

The S&P 500, which is supposed to represent a diversified mix of 500 companies, has been effectively commandeered by NVIDIA and a handful of other gigantic tech firms. Consequently, the S&P 500 has its highest concentration risk in recent memory.

Courtesy: Game of Trades

As you can see in the chart shown above, disaster struck soon after the S&P 500 became heavily concentrated with technology stock weightings in 2000. Back then, it was Cisco and Qualcomm; now, it’s overvalued companies that concentrate on anything and everything having to do with artificial intelligence (AI).

It’s a precarious situation in which experts are considering material damage to entire large-cap market indexes if just one stock, NVIDIA, falls. “Mathematically, given that it’s the largest stock in the U.S. market, if it goes down, the market kind of has to go down,” contemplated Melissa Brown, managing director of applied research at SimCorp.

How did mega-cap stocks get so far ahead of small caps? It mostly has to do with the Federal Reserve’s interest rate policy. When borrowing costs are high, it’s harder on small businesses that require start-up capital than it is on gigantic corporations with deep pockets.

Really, then, it’s a question of whether you believe that the Fed will lower interest rates at some point. I’d say that’s a foregone conclusion, as the government can’t easily afford to pay its debt at a high interest rate for much longer.

Plus, there’s the catch-up principle, which is related to the concept of market rotation. When a very large segment of the economy, such as small businesses, lags for a while, it’s like a coiled spring. Sooner or later, the best small-cap stocks that lagged for months or years could catapult higher very quickly.

Courtesy: @charliebilello

Now, in mid-2024, there’s plenty of room for small-cap stocks to play catch-up. Believe it or not, a large basket of small-cap stocks is still negative on a year-to-date basis.

It’s difficult to predict when the laggards will become the leaders. However, it’s historically unusual for a large group of small-cap stocks to stay range-bound for such a long time.

Besides, the idea isn’t to wait for every small-cap stock to break out. Again, your focus should be on the best small-cap businesses, as index funds will invariably include some less-than-stellar companies.

If you conduct your research and pick the right small-cap stocks, they can sometimes stage breathtaking rallies that make NVIDIA stock look like a laggard. As always, due diligence and proper position sizing are essential. Follow safety-first principles and, if you’re ready, try catching some small-cap standouts for potentially big price moves in 2024.