While large-cap stocks continue to flirt with new all-time highs, small-caps stocks are already there — with potential for even more upside in 2013.
Fueled by a recovering broader economy and housing market, re-accelerating earnings growth and a pickup in merger-and-acquisition activity, small-cap stocks are poised to outperform their large-cap peers again this year. In 2012, small-caps, as represented by the Russell 2000, rose 15 percent versus a 13 percent rise for the large-cap S&P 500.
Bank of America/Merrill Lynch small-cap strategist Steven DeSanctis expects small-caps to return more than 20 percent in 2013.
But investors shouldn't be surprised if stocks pullback in the near-term before motoring higher again.
Strong M&A Environment for 2013
An expected increase in mergers and acquisitions is one reason for DeSanctis's fairly aggressive outlook.
"M&A activity has really begun to pick up and that will help overall performance," DeSanctis said, describing M&A as one of the key themes for 2013. It's still tricky for companies to generate organic revenue growth. That's why companies are instead likely to buy top-line growth by acquiring smaller players — good news for the small guys.
Dan Veru, chief investment officer at Palisade Capital Management, agreed, and told CNBC this week an M&A super-cycle is just getting started.
"Top-line growth is going to be tepid at best so companies are going to … create top-line growth by buying it," he said, adding that small caps are "the place to be" this year.
Profit Margins Maxed Out
There's more reason to expect a much stronger M&A environment this year. Not only is debt financing still cheap, but big companies are finding it more difficult to meet earnings estimates as revenue growth remains fairly tepid given the slow economic recovery.
Plus profit margins sit at historic highs. After years of slashing costs, there are fewer levers big companies can pull to further fatten margins. According to a blog post from AllianceBernstein market strategist Vadim Zlotnikov, toward the end of last year net profit margins of U.S. companies reached historic peaks of 7 percent — well above the 15-year average of 5.6 percent.
Noted strategist Byron Wien told CNBC this week he expects both earnings and the economy to disappoint. "Revenue growth will be modest and some costs will increase, so I think earnings estimates will be trimmed down," he said.
Given this financial reality for many companies, an acquisition is among the few options left to bolster growth in an environment where roughly 2 percent gross domestic product growth is the best that can be hoped for.
"The only way companies have a shot at meeting growth expectations is by buying," said Uri Landesman, president of hedge fund Platinum Partners. He expects this secular trend to help small-caps outperform, but is negative on the overall market, calling for an overall correction of as much as 15 percent.
A Lot to Like About Small Caps
Small-caps look attractive to both investors and potential acquirers because of their strong balance sheets and good earnings momentum. Unlike large caps, smaller companies have more room to cut costs to boost margins. "Profit margins have exceeded the old highs for the S&P 500 but have yet to exceed the old highs for the Russell 2000," said Veru of Palisade Capital Management.
Small caps are also attractively valued. While the Russell 2000 is sitting at all-time highs, small caps trade on just 15.4-times expected earnings, according to DeSanctis. At previous peaks, they traded at 17-times — suggesting room for more gains.
After investors flocked to yield and safety amid ongoing global economic uncertainty, small-caps have split into two camps — dividend payers and non-dividend payers, said Seth Reicher, president of Snyder Capital Management.
(Read More: History Suggests a Good Year for the Bulls)
"Companies that pay out dividends are expensive," said Reicher, whose firm manages $2 billion. "Companies that have high free-cash-flow yields and don't pay out dividends are inexpensive. That's where the opportunity is."
Reicher, a value investor, said M&A should pick up this year as some of the macro uncertainty starts to dissipate. Companies should start looking longer term instead of worrying about political and macro flare-ups such as federal budget talks in the near term.
Tech and Health Care
So which sectors are likely to see a pick up in acquisition activity?
Both Platinum Partners' Landesman and BofA's DeSanctis expect the technology and health-care sectors to be the hunting grounds for deals.
DeSanctis, who prefers growth over value, said both sectors have attractively valued stocks with strong balance sheets. "If M&A picks up, techs will lead," he said.
He also said uncertain fiscal policy and the potential impact from Obamacare are already reflected in the valuation of health-care stocks.
Landesman forecasts biotech deals as larger companies look to fill out pipelines and bolster growth. For a smaller company, it often makes sense to sell out to bigger drug makers with an existing sales force than to invest in building their own, he said.
M&A has already begun to pick up with 13 deals involving Russell 2000 companies so far this year. "Within Palisades portfolios, we've seen that trend go for the last two years or so, where 30 or more companies have been acquired mainly by strategic buyers at significantly higher valuations than previous day's close," Veru said. "That cycle is only beginning."