Small-cap stocks rally after Fed rate-cuts start. Here's how to find winners.

By Michael Brush

Use these pro tips to buy and sell shares of small, undervalued companies

When the U.S. Federal Reserve starts a rate-cutting campaign, small-cap stocks are among the best performers.

Small companies typically have more variable-rate debt than large ones and they do better when business confidence improves, which happens as the Fed cuts rates. Small-caps are more likely to be in cyclical businesses, which outperform when the economy is in shape. Moreover, small companies are mostly domestic operations, so they benefit directly when rate cuts boost U.S. growth.

Here is another tailwind for small caps: They have a lot of ground to make up. The Russell 2000 RUT P/E recently was 0.74 times that of the larger-cap Russell 1000 RUI Index. Normally these two baskets of stocks trade for the same P/E, according to Bank of America quant strategist Jill Carey Hall. This discount suggests 9% annualized returns for the Russell 2000 over the next decade compared to 2% per year for the Russell 1000, Hall adds.

But small-cap investing can be tricky. Mick Rasmussen, manager of the Wasatch Long/Short Alpha Fund (WALSX WALSX), has a terrific record with small caps. The fund is up 32.5% in the past year compared to 17.2% for competing funds and 29% for its benchmark index, according to Morningstar Direct. Over the past three years, the fund is up around 51% compared to roughly 2% for the Russell 2000.

Here are five tips from Rasmussen on what to look for in the small-cap space, with examples of some of his current favorite stocks.

1. Quality management: "With small caps, management is a much bigger differentiator than at large caps," Rasmussen says. There's also a wider spectrum of what defines quality. So, knowing management is key. Rasmussen has an advantage over individual investors because he gets to meet with management. "We often have known the management for many years before we initiate a position," he says.

But we all can spot winning qualities by listening to earnings calls and looking at management track records. One is the consistency of the company's message. "Are they changing their tactics and message often, like snake-oil salesmen?" Rasmussen said. Another sign of quality is when management follows through on what it says it will do.

Rasmussen also likes to see management teams that perform well in different economic environments. Management quality also shows up in superior performance metrics - such as return on invested capital.

One company in the portfolio that displays exceptional management is Ensign Group (ENSG), the fund's top holding. Ensign manages skilled nursing facilities. "Ensign Group has shown an ability to deploy capital to acquire undeforming skilled nursing facilities and apply their approach which has led to huge amounts of value creation," Rasmussen says.

2. Long-term growth: Rasmussen likes to see long-duration growth prospects that the market is missing. For example, investors might dismiss a company as "already discovered," because of a high P/E multiple. "But if a company can produce double-digit earnings growth for 10 years, you can pay a high multiple," Rasmussen says. It helps when a company can finance its own growth with strong cash flow.

Here, Rasmussen singles out UFP Technologies (UFPT), which makes components used in sophisticated medical equipment. The surgery-robot company Intuitive Surgical (ISRG) is a big customer. But UFP is diversifying away from Intuitive Surgical by finding other medical-equipment components to manufacture. It uses its cash flow to fund acquisitions to get this done.

The medical-device maker Novanta (NOVT) is another example of a portfolio holding with long-term growth potential. Rasmussen says Novanta can grow earnings by 15% a year for the next 10 years by expanding into new product lines.

3. Large inside ownership: Rasmussen appreciates management with significant share holdings - giving them "skin in the game." Here, he singles out Paylocity Holding (PCTY) in payroll and human-resource software and Xpel (XPEL), which offers specialized protective coatings for automobiles. Insiders at both companies own more than 20% of the stock.

4. Let winners ride: Rasmussen was originally hired by Wasatch to analyze trading data to figure out how the firm could perform better. One insight he uncovered was that Wasatch was quick to take profits as the thesis on a business started to play out. Now, instead of taking profits quickly, the firm is more apt to look at stock gains and improvements in metrics including margins, cash flow and earnings revisions as a signal to buy more shares precisely because the original thesis is working.

An example is Guidewire Software (GWRE), which offers software that insurance companies use to manage their business. Insurance companies are slow to change. But they are coming around to using cloud-based software - a necessary step to incorporate AI into their models.

Michael Brush is a columnist for MarketWatch. At the time of publication, he owned NVDA, MSFT, GOOGL and GWRE. Brush has suggested NVDA, MSFT, GOOGL and GWRE in his stock newsletter, Brush Up on Stocks. Follow him on X @mbrushstocks.

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-Michael Brush

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10-07-24 1030ET

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