Small-cap stocks were big winners. Because they can continue to perform better.

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Good things are supposed to come in small packages, but that hasn’t been the case for small-cap stocks this year. That could change.

The recent bear market hit small-cap stocks particularly hard. The

Russell 2000
The index fell 32% from its all-time closing high in November to its June 2022 low. That’s much worse than

S&P 500’s
24% drop from top to bottom. But it makes sense. Small companies are hit harder by rising interest rates and a slowing economy than their larger counterparts, and it’s been a long time since the Fed has been forced to raise rates as quickly as this year.

Now, the Fed appears poised to slow the pace of its rate hikes – the Fed-funds futures market is pricing in just a 26% chance of a three-quarter hike at its next meeting in September, down from about 60% just one a day ago week—and those lowered expectations were great news for small caps. The Russell 2000 is up 14.3% from its mid-June low, outpacing the S&P 500’s 12.6% gain over the same period.

Small caps seem to follow a familiar pattern, underperforming before a recession and then outperforming coming out of one. That’s what happened in 1990, 2001, 2008 and 2020, according to Lori Calvasina, chief U.S. equity strategist at RBC Capital Markets, when small-caps underperformed large-caps leading into the recession before outperforming. at the exit.

“We now feel comfortable telling investors to get fat with the small cap,” he writes.

Of course, for this to work, small caps had to be priced into both Fed rate hikes and the recession that usually follows. Their valuations show they already have. The Russell 2000 recently traded at just 13 times forward 12-month earnings, near the lowest it has hit since the 2008-09 financial crisis, according to

the bank of america
.

“[We] I think the risks are largely discounted,” writes BofA Securities strategist Jill Carey Hall.

However, there is a lot of junk in the small-cap indices and investors should look for quality companies. Jefferies strategists favor “growth at a reasonable price,” a strategy that performed well during the recent market rally. Such stocks have strong earnings-growth expectations, but are profitable and likely won’t need to raise capital if the economy takes another turn for the worse. The generals found 18 examples, among them

Armstrong World Industries

(AWI) and

Capri Holdings

(CPRI).

Yeti Holdings

(YETI) looks particularly interesting. The $4.4 billion high-tech cooler maker has taken market share from Igloo and

Newell Brands

(NWL) Coleman with patented technology that allows it to keep food and drinks cooler for longer, explains Miles Lewis of Royce Investment Partners, which owns Yeti. The company is still growing, with cooler sales expected to increase in the mid-2023s. And it has added new products, which should ease concerns that its growth will slow.

“People think they are [Yeti] a one-trick pony,” says Lewis. “Now they have a drinks business.”

Sales are expected to grow annually at a rate of 12% over the next two years to $2.1 billion, according to FactSet. That would lift earnings per share about 15% annually to $3.82 through 2024, which could propel the stock higher. At $50.77, it trades at about 15 times forward earnings, just over half its five-year average of 26 times.

There is nothing better than small companies with big prospects.

Write to Jacob Sonenshine at jacob.sonenshine@barrons.com