Goldman's small-cap picks for falling inflation

Published Tue, Jan 24 202310:12 PM EST

Hakyung Kim @https://www.linkedin.com/in/hakyungkim/@hakyungkim_

Many small-cap stocks took a beating in 2022, as sharply rising costs hurt profits, but the situation could be reversing, Goldman said, creating an opportunity for investors if they know where to look. "With inflation expected to moderate, companies that can at a minimum stabilize their gross margins this year and meaningfully expand them beyond that should be well positioned in our view," said analyst Deep Mehta in a research note. The consumer price index has fallen from a peak 9.1% rate last June, but remains high. In December, consumer prices were up 6.5% from the prior year. Economists are expecting the trend to continue , as the Federal Reserve hikes interest rates to cool things off. Inflation and the Fed's rate hikes have weighed on stocks. Last year, the Russell 2000 fell 22% from 2021, its worst annual performance since 2008. By scanning small-cap names that underperformed as quickly rising costs cut into earnings, investors may find stocks that are likely to show the biggest benefits as the price of energy, transportation and other materials ease. Goldman screened small-cap stocks that are expected to show gross margin expansion through 2024. The bank found companies that reported gross margin declines of more than 50 basis points, and those that could see gross margins expand at least 100 basis points from 2022 to 2024. A basis point equals 0.01 of a percentage point. The following names showed the biggest gains between the two time periods, making them Goldman's picks as inflation decelerates. Allegiant Travel , the parent of low-cost airline Allegiant Air, is expected to see its margins increase. Airlines were hurt by rapidly rising energy costs last year. But lower energy costs are one of the factors driving consumer prices down. Goldman said there is a risk of a trade down as the economy slows. That would reverse Allegiant's key 2022 tailwind: the pent-up desire to travel. Apparel and accessories retailer Gap is estimated to see its margins improve 260 basis points from 2022 to 2024, Goldman said in the note. The company is benefiting from new management that is focused on improving the company's operating expenses. High transportation costs were a hit to Gap's bottom line last year, and those expenses should ease in the year ahead. Consumers also may be more willing to spend on clothes when less of their paychecks are eaten up by food and rent. More discretionary income could also help Rent the Runway , which completed an IPO in 2021. The company has struggled since its business took a hit from the pandemic. But the clothes-sharing startup is on track to drive its margins higher as it partners with more third-party retailers. It recently announced a collaboration with Amazon . Rent the Runway CEO Jennifer Hyman said the relationship could be a "key engine" of growth for the retailer. The Russell 2000 has also begun to rebound in recent weeks, moving higher on the hopes that the ultra-high levels of inflation seen in 2022 are finally breaking. The small-cap index has gained 7.4% year-to-date in 2023.