The small-cap market is experiencing a pivotal moment (see our blogs on The Great Rotation into Small Caps and on Market Dynamics and Economic Shifts). If you haven’t made any investment allocations to this sector, now may be the right time. The “Great Rotation” is already underway, with investors shifting their focus from large-cap stocks, which have led the market for years, into more undervalued and potentially higher-growth small-cap equities. This is a critical time to get on board before the opportunity passes by.
At Ironwood Investment Management, LLC, we specialize in the small cap sector and have focused on the small cap space since our founding in 1997. Our success stems from its disciplined, fundamental approach focused on identifying high-quality small cap companies trading at attractive valuations. Our flagship Small Cap Core Strategy has delivered a track record of outperformance through multiple market cycles: since inception (1/1/1999), the strategy has returned 11.7% gross of fees in average annual return versus 8.1% for the Russell 2000, the strategy’s benchmark, an out performance of over 369 bps.
The Fed’s Interest Rate Cuts: A Catalyst for Small-Cap Stocks
The Federal Reserve’s recent decision to cut interest rates marks a turning point. Lower rates tend to benefit smaller companies, particularly in sectors like banks, utilities, real estate, and industrials. Why? Small-cap companies are generally more sensitive to changes in borrowing costs because they rely more heavily on financing for growth. When interest rates drop, their cost of capital declines, giving them room to expand and improve profitability. These smaller firms tend to outperform larger corporations during such periods.
Moreover, as inflation steadily cools and approaches the Fed’s target, the U.S. economy may be well-positioned for continued growth. Small-cap stocks, which often flourish during economic expansions, stand to benefit from this macroeconomic tailwind. Investors who are early to allocate to small caps may capture outsized returns as the market catches up to this opportunity.
Broader Market Trends and the Great Rotation
We are also witnessing a broadening rally in the U.S. stock market—a trend that has shifted the spotlight away from large-cap growth stocks, particularly in the technology sector, to smaller, more cyclically sensitive companies. In recent years, large-cap names like Apple (AAPL), Microsoft (MSFT), and Nvidia (NVDA) have driven much of the market’s gains, but as these stocks reach historically high valuations, investors may increasingly seek opportunities in undervalued sectors. This rotation into small-cap stocks is expected to continue, especially as valuations for large caps, such as the S&P 500, approach a price-to-earnings (P/E) ratio of 25x for 2024—well above the historical average.
In contrast, small-cap valuations, particularly those in the Russell 2000 Index, remain more attractive, with earnings expected to grow faster than their larger-cap counterparts. This creates a window of opportunity for investors looking to enter the small-cap space before valuations catch up with the broader market rally. At Ironwood, we are focused on identifying these undervalued gems, where there is significant upside potential.
Small-Cap Performance in Historical Context
Historically, small-cap stocks have shown a tendency to outperform during periods of declining interest rates. We’ve seen this play out multiple times: following the dot-com bubble in the early 2000s, during the global financial crisis, and most recently in the aftermath of the COVID-19 pandemic. Each of these periods was marked by a rotation into small caps, driven by improving economic conditions and lower borrowing costs. Check out our blog post on this topic.
In July 2024, as interest rate cuts became more likely, the Russell 2000 Small Cap Index surged by over 10%, significantly outpacing the 1% gain in the S&P 500. This outperformance may be a signal that small-cap stocks are entering a favorable phase, and savvy investors should take note. As economic expansion continues and interest rates fall further, we anticipate small-cap stocks leading the overall market.
Now is the Time to Act!
Waiting for the perfect moment to invest can mean missing out on the most opportune time. The small-cap train is leaving the station! Investors who hesitate may risk missing an opportunity to capitalize on these potentially favorable conditions. With the U.S. economy on solid footing, corporate earnings growing, and more interest rate cuts expected in 2024-2025, the conditions are right for small-cap stocks to thrive.
At Ironwood, we believe in the power of disciplined, research-driven investing. Our focus on small-cap companies with strong fundamentals, healthy balance sheets, and robust growth potential positions us to navigate this dynamic market effectively. These are the companies that have been overlooked in the recent large-cap-driven rally but now may be poised for growth as the market rotates.
Conclusion: Don’t Miss the Train
The time to act is now. Small-cap stocks seem primed to take advantage of the favorable macroeconomic environment, and those who invest early may be positioned to reap the rewards as this rotation plays out. At Ironwood, we are dedicated to finding these opportunities and ensuring our clients are well-positioned to benefit from the coming shift in market dynamics.
Contact us to learn more about our strategy and decades of performance. The small-cap train is leaving the station—get on board before it’s too late!
PERFORMANCE DATA AND DISCLOSURES
Performance Statistics as of 9/30/2024
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.