Wall Street pros say these small caps are good buys as recession looms — BofA gives one 40% upside

Published Tue, Aug 2 20229:41 PM EDTUpdated Tue, Aug 2 202210:44 PM EDT

Large-cap stocks are typically seen as safe bets in periods of volatility, but a slew of Wall Street pros think small caps are looking increasingly attractive as recession risks grow. Small-cap stocks have often received less love compared to their larger counterparts given the former's perceived earnings volatility, greater domestic bias, and lower visibility. They are also often shunned during market volatility in favor of more stable options. But history suggests investors could be mistaken. "Historically, recessions have tended to be good buying opportunities for small caps," Lori Calvasina, head of U.S. equity strategy at RBC Capital Markets, said in a Jul. 22 note. "It also appears to us that small-caps are baking in a lot of economic pain already." The brokerage believes small-cap stocks are "very close" to pricing in recession, which can be seen "fairly clearly" in valuations. It noted that small-cap stocks now look historically cheap relative to large-cap counterparts, with the small-cap Russell 2000 Index trading in a price-to-earnings range that "tends to mark its bottom." Small caps do not just outperform in a recession, they also do so for an extended period after an economy emerges from the throes of a downturn, according to Christian Galipeau, senior market strategist at Putnam Investments. He observed that small cap stocks tended to underperform large cap stocks in the months leading up to and during a recession, well as "for the next three years" as the economy exits a recession. Citigroup noted that small-caps were the first to weaken as inflationary pressures took hold, and in turn, could now be "the first to recover." It said the valuations of small-cap stocks are implying they are "significantly de-risked," and pricing in recession fears. "The small versus large-cap trade is near post-Financial Crisis lows and relative valuation is not far off its 20-year bottom," Citigroup's strategists, led by Scott Chronert, wrote in a Jul. 26 note. Bank of America's top stock ideas Bank of America says "much has changed" since the start of this year, given a few developments: Fed policy, geopolitics, market volatility, rampant inflation and recession fears. "But volatility and regime shifts present opportunities, and we continue to see a favorable backdrop for stock-picking," Bank of America strategist Jill Hall wrote in a recent report. It noted that stocks with defensible margins and pricing power have been rewarded in an environment of rising interest rates and inflation. The bank likes food delivery provider DoorDash , which it said is not directly exposed to raw goods and food price inflation given its position as a third-party platform. The bank has a price target of $90 on the stock, which closed at $72 on Monday, representing a potential upside of 20%. Bank of America also likes Illinois-based Option Care Health as the least exposed home care name to labor cost pressures. The company could see further upside as it deploys improved free cash flow, Hall said. The bank's price target of $38 on the stock implies a potential upside of 11.8% to the stock's closing price of around $34 on Monday. Read more Has the market hit bottom? Here’s what Wall Street has to say after U.S. stocks rebound in July Is the U.S. in a recession? This strategist is watching 14 indicators Top tech analyst says this FAANG stock is at an ‘inflection point’ — and gives it 33% upside Florida-based electronics manufacturer Jabil also made the list. The company is levered to end markets that are seeing secular growth, as well as sectors such as health care, which the bank sees as "generally recession proof." Its shares closed at around $59 on Monday, which implies upside of 40% to the bank's price target of $82 on the stock. Bank of America also likes chipmaker ON Semiconductor , for its strong turnaround potential, superior product, and exposure to hyper growth trends in electric vehicles. The bank has ascribed a price target of $80, which represents a potential upside of 25% to the stock's closing price of around $64 on Aug. 1. Barclays also named a slew of overweight-rated "high conviction" small cap stocks that it thinks offers the potential for superior risk-adjusted returns. The bank's picks include cybersecurity firm CyberArk , biopharmaceutical firm Sarepta Therapeutics , and homebuilder Skyline Champion .