Small-Caps Are Fading: Key Stocks That Could Continue to Rally

In recent months, small-cap stocks have surged significantly, with the S&P 600 index experiencing a remarkable increase of 16% this year alone. As of now, this index, which boasts an average market capitalization of approximately $3 billion, has reached record highs following the various policy proposals made by President-elect Donald Trump. However, as market dynamics shift, the trend may not continue for all small-cap stocks.

The Rise of Small-Caps

The significant uptick in small-cap valuations can be attributed to projected fiscal spending, which could reach tens of billions of dollars annually. This projected influx is expected to enhance economic conditions and consequently bolster the performance of small-cap stocks, as these are more heavily weighted toward economically sensitive sectors compared to the large-cap S&P 500.

A key factor driving this enthusiasm is the anticipated tax cuts, specifically aimed at companies manufacturing domestically. Given that the S&P 600 is predominantly domestically focused, these tax initiatives may provide considerable advantages for its constituents. Nevertheless, with the index currently pricing at just below 1510, it has not hit new highs for weeks, indicating that investor enthusiasm might be starting to wane.

Market Inflows and Future Outlook

Data from Bank of America reveals that approximately $30 billion has flowed into U.S. small-cap funds this year, marking a record inflow that is nearly three times higher than last year. However, the potential for further inflows is limited. Historical trends show that following record inflows, small-caps frequently see net outflows in subsequent years. According to Dennis DeBusschere from 22V Research, the current lack of a new catalyst suggests that small-cap stocks may struggle to maintain their recent rally as we move towards year-end.

Currently, the S&P 600 is priced at 17 times the aggregate earnings projected for 2025, a notable increase from a little over 14 times at the start of this year. While this valuation remains lower than the S&P 500’s valuation of over 22 times, the gap is narrowing. Analysts caution that any disappointments in earnings could result in significant losses for smaller companies, making it clear that they are at a “show me” stage where future earnings must outpace expectations.

Identifying Promising Small-Cap Stocks

In light of these trends, Barron’s conducted a search for small-cap stocks within the S&P 600 that are poised for continued growth. The screening criteria included companies that have exceeded analyst earnings estimates in at least seven out of the past eight quarters, possess an expected earnings growth of at least 10% for both 2025 and 2026, and are trading at multiples below the S&P 600’s price-to-earnings ratio.

Highlighting Six Growth-Oriented Stocks

The search yielded 23 promising stocks, including:

• Enova International ($2.7 billion market cap) – An online lender poised for growth.
• Allegiant Travel ($1.5 billion market cap) – Noted for its operational efficiency and service offerings.
• LiveRamp Holdings ($2.1 billion market cap) – A strong player in the software-as-a-service sector.
• Mr. Cooper Group ($6.2 billion market cap) – A mortgage servicing company with promising prospects.
• Steven Madden ($3.2 billion market cap) – This fashion brand has shown strong international sales growth.
• Tripadvisor ($2 billion market cap) – Continues to grow despite competition in the travel sector.

In-Depth Analysis of Selected Stocks

Steven Madden, trading at 15.3 times earnings, has surpassed earnings expectations consistently over the past two years. Management indicated that they are on track to achieve mid-teens growth in international sales, contributing to an expected total revenue growth to $2.49 billion by 2026.

Meanwhile, Tripadvisor, trading at a reasonable 10.8 times earnings, has managed to show sales growth consistently since 2020. It is expected to generate revenue growth of 7% annually, positioning itself for continued success within the expanding travel market, especially as it leverages technology like an artificial intelligence assistant on its platform.

Conclusion: Navigating the Small-Cap Terrain

As the small-cap stock landscape continues to evolve, investors must remain vigilant. While certain stocks, such as those highlighted above, show potential for ongoing growth based on their solid performance and future earnings projections, the broader market’s tendencies indicate a cautious approach may be warranted. Ultimately, as earnings reports loom and market conditions fluctuate, it will be essential for small-cap stocks to validate their valuations through performance.