Small-cap stocks could explode higher in 2024 for two reasons. First, small-cap stocks are cheap overall and could move higher to more normal valuations. Second, market conditions in 2024 could actually help make such a move happen.
Let's break this down to fully appreciate what's going on here.
The case for small-cap stocks in 2024
A small-cap stock is generally defined as a company with a market capitalization below $2 billion. These can be businesses from any industry, they're just smaller than many of the household names most investors are familiar with.
For tracking large companies, investors usually focus on the S&P 500 index, a collection of roughly 500 of the largest, most profitable U.S. businesses. To track small-cap stocks, there's the Russell 2000 index.
As smaller companies, small-cap stocks are often more reliant on outside financing, and that's key to this discussion. According to recent FactSet data shared by Lazard Fund Managers, Russell 2000 companies have a net-debt-to-EBITDA (earnings before interest, taxes, depreciation, and amortization) ratio of 3.2, compared with an average of 1.6 for the S&P 500. In simple terms, small-cap companies have twice as much debt as large-cap companies right now relative to their profits.
This means that debt servicing is a big deal for these small businesses. And according to the same data from FactSet, only 55% of Russell 2000 companies have fixed-rate debt, compared with 91% for the S&P 500. Therefore, interest rates are also a big deal.
Tom Lee of Fundstrat Global Advisors believes that inflation is getting under control so the Federal Reserve will consequently lower interest rates in 2024. Many on Wall Street agree there could be six rate cuts. Because of this, Lee believes small-caps stocks will be well positioned in the coming year. Debt servicing will get cheaper, leaving the small-cap stocks with more cash to deploy across their businesses.
For this reason, Lee believes the Russell 2000 could surge roughly 50% next year alone, according to a recent interview with CNBC. For what it's worth, the financial analyst predicted the S&P 500 would finish 2023 at 4,750. It's within 1% of that mark with less than a week to go.
While a 50% annual gain for the Russell 2000 might seem extreme, investors need to understand that small-cap stocks are starting the year at abnormally low valuations. The S&P SmallCap 600 is another index for tracking small-cap stocks. These 600 stocks trade at an average forward price-to-earnings (forward P/E) ratio of 15.1. That's well below the average for the last decade and much cheaper than the forward P/E of 19.8 for the S&P 500.
This valuation gap between small-cap stocks and large-cap stocks is near its highest level in the last 20 years. This suggests small-cap stocks are undervalued, and their valuations have room to increase. Then, there's the fact business fundamentals could also improve thanks to falling interest rates, boosting stock prices further.
What investors should do now
This information shouldn't result in a major shift to your portfolio allocation or investing strategy. Just because small-cap stocks are generally well positioned for 2024 doesn't mean there aren't good large-cap stocks to buy as well. Moreover, knowing that small-cap stocks will rise doesn't mean they will all rise -- investors must still be selective.
As a general takeaway, it may be good to look for small-cap stocks that don't have debt problems. It's possible some are cheap like the rest of their small-cap peers, and those without heavy debt loads could be in a position to thrive regardless of what happens with interest rates.
For example, premium audio company Sonos (SONO 1.63%) might fit this description. Trading at 1.4 times sales, the stock is inexpensive. The company's audio devices have loyal fans who frequently buy new products over time and tell their friends. The business is experiencing a slowdown now, but I'm confident Sonos will still be around for the long haul.
Investors shouldn't overlook learning marketplace Udemy (UDMY +3.23%) either. The company offers a fast-growing subscription service to supply educational content to enterprises. This content is all user-generated, which allows it to amass a vast library quickly. And it'll soon lower its creator payout, which will boost its own profitability.
These are just a couple of stock ideas based on the general takeaways of this article. Investors need to remember that having an awareness of broad market conditions can guide your decision making, but it isn't a substitute for researching individual stocks to find good opportunities.
