The Great Rotation into Small Cap Stocks: An Overview
The financial markets have recently witnessed a shift, often referred to as the “Great Rotation,” where investors are increasingly turning their attention from large-cap stocks, particularly in the technology sector, and into small-cap stocks. This trend is characterized by a noticeable movement away from the “Magnificent Seven” group of major tech stocks to smaller, more cyclically sensitive companies. (See the Winter 2024 letter from Ironwood’s Executive Managing Partner, Don Collins, for more analysis on the Magnificent Seven and related market trends.) The shift has been dramatic, with the Russell 2000 index, which tracks smaller stocks, outperforming the S&P 500 in recent weeks.¹
Dynamics Behind the Rotation²
Several factors contribute to this rotation. Firstly, changes in Federal Reserve policy, particularly expectations of future interest rate cuts, have played a crucial role. As inflation pressures ease, the market anticipates that the Fed will start reducing rates, potentially as soon as September. This scenario benefits smaller companies, which are typically more sensitive to borrowing costs and economic cycles.
Secondly, the concentration of gains in the S&P 500 has raised concerns about market stability. A handful of large-cap tech stocks, notably Nvidia, Microsoft, Amazon, and Apple, have driven much of the index’s performance, which has worried investors about the sustainability of this narrow leadership. In contrast, small-cap stocks offer a broader base for potential gains, appealing to investors seeking diversification.
Ironwood’s Strategy in the Small Cap Space
Ironwood Investment Management, LLC, based in Boston, has long recognized the opportunity in the small-cap space. Founded in 1997, Ironwood has developed a reputation for its disciplined investment approach, focusing on fundamental research and active portfolio management. The firm’s strategy, particularly through its Small Cap Core Strategy, emphasizes long-term investments in undervalued securities, often in companies with market capitalizations under $10 billion.
Key Elements of Ironwood’s Approach
1. High I-Q Companies: Ironwood’s investment philosophy revolves around identifying “High Ironwood Quality” companies. These are firms with exceptional management teams, strong current market positions, and future growth opportunities. The firm emphasizes companies that not only perform well financially but also the Ironwood Small Cap Core strategy demonstrates thoughtful approaches to Environmental, Social, and Governance (ESG) issues.
2. Discipline and Research: Ironwood prides itself on a rigorous approach to research and analysis. This method involves a deep understanding of market dynamics and a focus on companies that the market may undervalue due to short-term concerns. This strategy aligns with the firm’s belief that markets often overreact to short-term events, and that patient, prudent investment can unlock long-term value.
3. Sustainable Growth: The Ironwood Small Cap Core Strategy’s commitment to sustainability is not just about ESG criteria but also about the resilience of its investment strategy. Ironwood’s approach has proven effective across various market cycles, demonstrating the firm’s ability to adapt and thrive even in challenging conditions. This adaptability is crucial, especially in the current market environment where small-cap stocks are gaining renewed interest.
Learn more here about Ironwood’s Track Record of Success.
The Road Ahead for Small Cap Stocks
The current rotation into small-cap stocks suggests a broader recognition of the value and growth potential in this segment of the market. The expectation of lower interest rates is likely to continue supporting this trend, as smaller companies generally benefit more from reduced borrowing costs compared to their larger counterparts. Moreover, the diversification benefits and the potential for upside gains make small-cap stocks an attractive option for investors looking to balance their portfolios.
For investors, the key will be identifying the right opportunities within the small-cap space. This involves looking beyond the headline numbers and focusing on the fundamentals of individual companies. Factors such as strong management, solid financial health, and a clear path to growth are crucial indicators of a company’s potential to perform.
Ironwood’s Role in Supporting Investors
Ironwood Investment Management, LLC, offers various strategies for investors interested in the small-cap market. The firm’s experience, coupled with its rigorous investment processes, makes it an excellent potential long-term partner for those looking to capitalize on the Great Rotation. With a track record of disciplined performance and a commitment to ethical investment practices, Ironwood provides a compelling proposition for investors seeking to navigate the complexities of the current market landscape. As evidence of this track record, the firm’s flagship Small Cap Core Strategy was recently ranked #1 “Top Gun” by PSN within the PSN Small Cap Core Universe for both quarterly and one-year returns, for the quarter ending March 31, 2024.³ Read more about Ironwood’s recent accolades in our blog post on that topic.
In conclusion, the Great Rotation into small-cap stocks represents a shift in market sentiment and strategy. As large-cap tech stocks face potential headwinds, small-cap stocks offer a promising alternative for growth and diversification. Ironwood’s long-term strategy and recent #1 ranking in this space both underscore the value of a disciplined, research-driven approach to investment. For investors looking to explore this segment, aligning with experienced managers like Ironwood could be a key step toward realizing their investment goals.
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FOOTNOTES
- https://www.wsj.com/finance/stocks/a-stock-market-rotation-of-historic-proportions-is-taking-shape-da9b6546
- https://www.economist.com/finance-and-economics/2024/07/18/why-investors-have-fallen-in-love-with-small-american-firms
- Awarded May 21, 2024. PSN is not a client, and no compensation was paid or received in exchange for the ranking. Register for free to view the full PSN Top Guns recipient list and award methodology: PSN Top Guns: https://psn.fi.informais.com/.
PERFORMANCE DATA AND DISCLOSURES
Ironwood Investment Management®, LLC (Ironwood) is an independently managed investment advisory firm providing investment advisory services to institutional clients, mutual funds and high-net-worth clients. The firm is a registered investment adviser with the Securities and Exchange Commission. SEC Registration does not imply a certain level of skill or training. Accounts in the Small Cap Core composite include separately managed, fully discretionary, fee-paying portfolios. Portfolios are invested in undervalued securities, the majority of which will have market capitalizations under $2.5 billion at cost, including securities with growth and/or value characteristics. Securities are considered undervalued when management believes the current share price does not accurately reflect the long-term economic value of the underlying company. Ironwood Investment Management, LLC claims compliance with the Global Investment Performance Standards (GIPS®) and has prepared and presented this report in compliance with the GIPS standards. Ironwood Investment Management, LLC has been independently verified for the periods January 1, 1999 through December 31, 2021. A firm that claims compliance with the GIPS standards must establish policies and procedures for complying with all the applicable requirements of the GIPS standards. Verification provides assurance on whether the firm’s policies and procedures related to composite and pooled fund maintenance, as well as the calculation, presentation, and distribution of performance, have been designed in compliance with the GIPS standards and have been implemented on a firm-wide basis. The Small Cap Core composite has had a performance examination for the periods July 1, 2002 to December 31, 2021. The verification and performance examination reports are available upon request. GIPS® is a registered trademark of CFA Institute. CFA Institute does not endorse or promote this organization, nor does it warrant the accuracy or quality of the content contained herein. The creation date of the composite: July 2002. Performance inception date of the composite: January 1, 1999. Prior to July 2002, portfolios were included in the composite when at least 75% of the portfolio was invested in equity securities and when at least 75% of the portfolio was invested according to the investment style of the composite. Subsequent to July, 2002, portfolios are included in the composite after the first full month of being fully invested. Returns are presented gross and net of management fees and include the reinvestment of all income. Net returns are calculated based on the highest fee of 1.00%. Investment management fees are 1.00% on the first $25 million, 0.90% on the next $25 million, 0.80% on the next $50 million, and 0.75% over $100 million on an annual basis and a client’s return will be reduced by these and other related expenses. The actual fee charged to an individual portfolio may vary by size and type of portfolio and may be negotiated. Actual investment advisory fees incurred by clients may vary. The Russell 2000 Index consists of the 2000 smallest stocks in the Russell 3000 Index that represents approximately 8% of the U.S. equity market capitalization. The indices have been reconstituted annually since 1989. Ironwood returns and Index performance reflect reinvested interest income and dividends, in U.S. dollars. A list of composite descriptions and a list of limited distribution pooled fund descriptions are available upon request. Past performance is not indicative of future results. Policies for valuing investments, calculating performance and preparing GIPS Reports are available upon request. Prior to May 2006, the Firm was known as Ironwood Capital Management, LLC.