Lauren Romeo: While the Magnificent Seven (Alphabet, Amazon, Apple, Meta, Microsoft, Nvidia, and Tesla) continue to dominate the headlines while driving a disproportionate share of large-cap’s gains, within the “quality company” cohort of small-cap is a legion of relatively unsung heroes—businesses that provide essential products or services enabling the technologies fueling the M7’s ascent. For example, semiconductor capital equipment companies such as FormFactor, which manufactures wafer probe cards, ONTO Innovations, which specializes in metrology and inspection, and MKS Instruments, an advanced components packaging maker, all provide critical tools that allow the manufacture of AI chips and high bandwidth memory. Other examples include Cirrus Logic, the sole-source provider of audio processors and amplifiers for iPhones that’s leveraging its high-performance mixed signal expertise into additional smartphone content such as camera controllers and power management. Fabrinet is a contract manufacturer of complex optical components that worked with Nvidia for more than two years to develop an 800g transceiver that is critical to AI applications in data communications networking, with the product now in the early innings of what should be a healthy sales ramp. With more attractive valuations than the M7 group, along with solid cash flow growth prospects and high returns on invested capital, these and other high-quality unsung heroes in the small-cap space appear to offer more compelling risk-reward propositions than the M7 while being poised to benefit from the same tailwinds.

Miles Lewis: I expect U.S. regional banks to be among the top performing groups in 2024. Fundamentals appear poised for stabilization and likely improvement, particularly in the second half of the year. Pressure on net interest margins, a function of rapidly rising interest rates, appears to be abating, especially in light of the Fed’s comments on December 13th. Some banks are already seeing margin expansion, while others are anticipating it in 2024. The recent decline in interest rates also bodes well for another issue that plagued the banking industry in 2023: marking security and loan portfolios to market values. I think loan growth could improve in 2024, particularly in commercial real estate, as transaction activity picks up. M&A also looks likely to pick up, which should boost market sentiment on the group.

Of course, there are potential headwinds. Any economic slowdown or a recession will likely bring higher credit costs to banks, but we believe these should be quite manageable. In addition, the accounting standards adopted in 2020 imply that much of this uptick in credit costs gets pulled forward into one or two quarters. Further regulation also appears likely, though this will probably impact banks with $100 billion or more in assets—not the smaller regional and community banks that we invest in.

Lastly, I think the strength of bank stocks during the recent rally may portend a shift in market leadership once the market rally is deemed sustainable. Since the market’s recent bottom in late October, small-cap banks have meaningfully outperformed the broader small cap indexes. Importantly, this was not the case coming out of either the 2008-09 Financial Crisis or Covid-driven market bottoms. This subtle, yet important shift in the dynamics of the small-cap market suggests that banks are poised for a strong run in 2024, one that’s rooted in improving fundamentals, poor stock performance in 2023, and attractive valuations.

Jay Kaplan: I’ve seen the uncertain state of the U.S. economy reflected in the sluggish performance—and depressed earnings—for many trucking and transportation-related small-cap businesses, where volumes have declined in 2023. Some of these companies have what look to me like attractively low valuations where the strength of the business, its management, and the prospects for recovery aren’t being recognized by other investors—which has given me the opportunity to buy shares at what I think are bargain prices. The first two quarters of 2024 may not see a turnaround for these companies’ shares, but if volumes begin to pick up in the second half of next year, I think these stocks could do very nicely.

Steven McBoyle: Real estate was the poster child for the pain caused by the recent rate hike cycle. The industry turned upside down, as spreads across many of the industry’s asset classes turned negative. For that reason, this real estate cycle saw transaction activity plummet, with some asset classes seeing Great Financial Crisis like declines, multi-family real estate being one example.

With recent clarity from the Fed and clarity on any recessionary effects—or importantly, lack thereof—soon to come, yield curve normalization will follow. Ample institutional capital remains on the sidelines, so it’s highly likely that real estate brokerage models will benefit greatly from a normalization in classic spread dynamics, and thus the industry should see a resurgence in transactional activity.

While we do not find a lot of quality in small-cap real estate management & development companies due to the principal underwriting risk as well as capital requirements, there are a select few that satisfy our quality standards: they are asset light, agency versus principal based activities businesses with strong balance sheets that could benefit from this dynamic.

Chuck Royce: After several challenging years on both an absolute and relative basis versus large-caps, I think that small-cap stocks are poised for a recovery. And while I usually prefer to avoid economic predictions, I also believe that many small-caps have already priced in a recession or economic slowdown—and many of our holdings have been preparing for those possibilities for some time.

The Russell 2000 Index is emerging by fits and starts out of a classic bear market; the small-cap index was down -17.8% from the last peak on 11/8/21 through 12/13/23. We see several catalysts that could revitalize small-cap returns, including the end of the rate hike cycle, moderating inflation, a strong labor market, and steady consumer spending. Additionally, the strength of capital spending, reshoring, the effects of the CHIPS and Science Act, and AI applications are all promising elements whose benefits have not yet registered fully for many small-caps, if at all.

I would add that the Russell 2000 had an annualized return of just 2.4% for the 5-year period ended 9/30/23—among the lowest 5-year returns since the index’s inception, showing that many small-caps have been treading water for the last few years. Yet lower-than-average annualized 5-year returns have been followed by higher-than-average returns over the next 5 years. In fact, the Russell 2000 had positive annualized 5-year returns 100% of the time—in all 81 previous low-return 5-year periods—averaging 14.9%, a mark well above its monthly rolling 5-year 10.4% return since inception. And as bottom-up small-cap stock pickers, we see the most significant factor as the cautiously optimistic tone that the majority of the management teams we’ve been speaking to have struck when talking about their companies’ long-term prospects. So, while the near-term view remains as cloudy as any we’ve seen, there are enough positives for me to have a highly constructive long-term view for small-cap performance going forward.

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