Small-cap stocks have been underperforming larger-cap stocks by a significant margin since the beginning of February. As of Monday’s close they’re down 11% since February 1 while large caps are down less than 1%.
What’s the deal? And where could they go next?
If we want to point the finger at a specific event the target would likely land on the failure of Silicon Valley Bank (SVB) back in the beginning of March.
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While the bank run at SVB didn’t directly impact many small-cap stocks (once the Fed stepped in to backstop uninsured deposits) the event increased recession risks and hurt investor confidence. That was especially true in rate-sensitive areas where a financial crisis, a credit crunch and/or tighter lending standards would really curb growth (or worse).
For obvious reasons, small community and regional banks are at the very top of the list. But not far behind are smaller industrial and energy companies too.
Unfortunately for the S&P 600 Small Cap Stock index these three sectors have a relatively high combined index weighting of 39%.
In contrast, financials, industrials and energy stocks carry a collective weight of just 26% in the S&P 500 index. That lower weighting, plus the greater stability of larger players, is one of the reasons the large-cap index has been so much more resilient than the small-cap index lately.
There are other discrepancies in sector performance between large- and small-cap stocks since February 1. For example, large-cap tech is outperforming small-cap tech. But again, if we want to point the finger of blame at one thing, it’s the SVB failure and resulting fallout that has been disproportionally harsher on smaller companies.
Where Do We Go From Here?
Should the 2023 financial crisis turn out to have more sting than bite small caps have a lot of room to make up. Naturally, the worst-performing sectors (financials, industrials, energy) should have the greatest near-term upside.
For that to happen we’ll need to see more evidence that the Fed’s Bank Term Funding Program (BTFP), which effectively backstopped the banks, will stop a credit crunch short in its tracks.
We also need to see more confidence in the economy. On that front, the Atlanta Fed’s GDPnow tracking model for Q1 2023 just popped up to 2.2% from 1.5% a week ago. The model continues to rise and fall based on the varying economic data as it comes in.
While I’d love to wave the checkered flag and say risks to the financial system are behind us the reality is it’s just going to take time to see how this all shakes out. With financial companies kicking off Q1 2023 reporting season this week, we will get some insights very soon.
That will be good. But we also need a bit more clarity on the inflation trajectory and the Fed’s hiking plan.
Market odds are that the FOMC will hike by another 25bps on May 3, then hold from there.
What Specific Small-Cap Stocks Are Good Buys Now?
As always, the safest bets are to buy index or sector ETFs. I think the iShares Core S&P Small-Cap (IJR) ETF is offering an inviting buying opportunity for longer-term investors right now.
For those with the risk tolerance to handle individual stocks, I have two ideas.
The first is TransMedics (TMDX).
This is a small-cap MedTech company that’s developing an organ care system for transplant surgeries. The backbone of the platform is their Organ Care System (OCS), which is a portable device that keeps donor organs warm and functioning almost as if organs are still in a human body. They are also able to monitor organ health.
TransMedics is an example of a company that’s revolutionizing a market that’s not only great for humanity but is also becoming a really viable business. Revenue was up over 200% last year and should be up more than 60% this year. Profitability is at least a couple years out.
There is still lots of work to do and this is a very logistics-heavy market with many challenges. But it’s also an exciting, high-growth company that not many investors are aware of.
Another potential opportunity is SiTime (SITM).
SiTime is a fabless semiconductor company providing MEMS (micro-electro-mechanical systems) and silicon-based timing systems. The company is recovering after supply-demand imbalances curbed growth at the tail end of the pandemic.
The company’s solutions allow electronics to do what they’re supposed to do, reliably. Apple is a major customer (+20% of revenue).
Despite some ongoing supply challenges, SiTime continues to roll out new products. It introduced four in the fourth quarter of 2022 and expects to introduce five more in 2023. These new solutions are helping to drive average selling prices (ASPs) higher, and management expects pricing in 2023 will be stronger than in 2022.
As it stands now, analysts see full-year 2023 revenue of about $210 million, down 26% from 2022. EPS should be down about 65%, to -$1.32. Then, in 2024, growth should return. Revenue should be up 30% and EPS should double. We’ll know more about the recovery trends in May, when SiTime is set to report Q1 2023 results.
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