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2 Small Caps Poised for a Big Bounce-Back

Small-cap stocks have been lagging their larger brethren for months, but that just leaves them with more room to grow when the market turns higher. Here are 2 ways to play it.

A small cap

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 9.5% since February 1 while large caps are actually positive%.

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 rolling failures of a number of regional banks.

While the bank unwinds have been fairly orderly, all things considered, (especially with the Fed backstop of SVB) these bank failures 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.

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 in its tracks.

We also need to see more confidence in the economy. On that front, the Atlanta Fed’s GDPnow tracking model for Q2 2023 just popped up to 2.9%. 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.

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 a pick.

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.

Tyler Laundon is chief analyst of the limited-subscription advisory, Cabot Small-Cap Confidential and grand slam advisory Cabot Early Opportunities. He has spent his entire career managing, consulting and analyzing start-up and small-cap companies. His hands-on experience has taught Tyler that the development of a superior business model is the biggest factor in determining a company’s long-term success. Accordingly, his research focuses on assessing the viability of management’s growth strategies, trends in addressable markets and achievement of major developmental milestones.