Small caps are on a tear this year. Here’s how investors are playing the rally.

Published Thu, Feb 16 202310:00 AM ESTUpdated Thu, Feb 16 202310:11 AM EST

Six weeks into the new year, and shares of small-cap companies are rallying in 2023, luring in investors who are eyeing some of the sector's growth names. Shares of small-capitalization companies, most of whose business is in the U.S. rather than overseas, and which are less sensitive to growth outside the U.S., have outpaced the broader market so far this year. The S & P 600 Smallcap index is up 10.2% through Wednesday, and the Russell 2000 small-cap index is higher by 10%, while the S & P 500 has risen 7.5% in 2023. Last year, the S & P 500 index sank 19.4% while the Russell 2000 dropped about 21.6%. "A regime change, if you will, is taking place in the market, where small caps are going to do better," said Francis Gannon, co-chief investment officer at Royce Investment Partners, which focuses on small caps. Prolonged underperformance Gannon points to smallcaps prolonged period of underperformance. The average annual total return for smallcaps in the five years through 2022 was 4.1%, for instance, against 9.4% for the S & P 500. "A lot of the winners of the past decade who benefited from zero interest rates, low inflation and the low nominal growth are not going to be the leaders going forward," he said. Now investors are pointing to the recent rally as proof that small caps are on the verge of a prolonged period of outperformance. Here are some companies they believe will excel in the future: Gannon pointed to Rogers Corporation ($2.8 billion market cap), an Arizona-based engineered materials producer, as offering a strong growth outlook and solid management. Royce, which buys small-caps at significant discounts and aims to hold them for three to five years, initially sold its shares of Rogers when DuPont offered to buy it in late 2021 for $277 per share in cash. When DuPont scrapped the deal in November , Royce reestablished a position. ROG 1Y mountain Rogers Corp. over past 12 months. Rogers develops a variety of materials used in wireless infrastructure, electric vehicles, energy management in smartphones and apparel, as well as other industrial applications. The stock is ahead about 26% year to date, after collapsing 56% in 2022. Gannon called Forward Air a smallcap ($2.7 billion mkt cap) with growth potential, saying the trucking services provider is well-positioned to gain market share as it pivots its business to handling shipping for high-value services. Forward shares are virtually unchanged this year, (they fell more than 13% in 2022), after seeing "unusually slow" demand in the fourth quarter, which CEO Tom Schmitt expects could bleed into a few quarters of 2023. For Gannon, "the key here for the market in general is focus on the companies that actually have cash flow and earnings, and that leads us to the exposure to industrials and material businesses, some technology companies, financial companies [and] energy." He added that small caps tend to outperform large-cap stocks in a "declining inflationary environment." Small-cap boom cycles last nearly a decade, Gannon said, anticipating years of higher returns ahead. What's more, small caps are often quick to react to economic activity since they generate most of their sales in the U.S., while larger companies rely more on international markets. 'Massively outperform' Michael Sesser, equity portfolio manager of the $558-million DWS Small Cap Core fund, believes small caps will "massively outperform" large caps over the next five to 10 years. The Morningstar-rated, four-star fund has returned 10.5% annually over the past 10 years vs 9.2% for the category and 9.3% for its index. Morningstar says it lands in the 14th performance percentile over 10 years. Cantaloupe , a retail service digital payments company with a $373 million market cap, and medical imaging provider RadNet ($1.2 billion market cap) are among Sesser's picks. Both are in the Russell 2000 index. Cantaloupe's stock price is up 21% so far this year, after plunging 51% in 2022. All four sell-side analysts who follow the company rate it a buy, and their average price target of $9 implies potential upside of 71% from Wednesday's close. DWS Small Cap bought the stock at the end of 2020, and is confident of its potential growth in light of record fourth quarter revenue gains, and Cantaloupe approaching 1.1 million active devices at the end of last year. Shares of RadNet have gained about 11% this year. The outpatient diagnostics provider has two buys and one hold from analysts, according to FactSet, with an average price target of $34, leaving potential upside of 63%. Sesser pointed to RadNet's track record of consolidating "mom-and-pop" imaging centers, and benefits from joint ventures with hospitals. DWS Small Cap also owns metallurgical coal producers serving the steel industry, namely Alpha Metallurgical Resources ($2.7 billion market cap), Arch Resources ($2.6 billion market cap) and Peabody Energy ($4.2 billion market cap). All have strong free cash flow yield and stand to indirectly benefit from the $1 trillion bipartisan infrastructure bill passed in November 2021 and the Inflation Reduction Act signed into law by President Biden last August. Craig Sarembock, a wealth advisor at Cincinnati-based Bartlett Wealth Management, sees the most opportunity in industrials and financials. He noted that small-cap companies are trading close to their lowest valuation in 20 years compared to larger companies, based on enterprise value to earnings before interest and taxes (EV/EBIT). "You've seen a lot of multiple compression over the course of the last year, obviously in large-cap stocks, but more so in small-cap stocks," Sarembock said. "They're looking even more attractive than they have for the last decade." Jefferies' small- and midcap strategist Steven DeSanctis is sticking with value and cyclical smallcaps, noting that earnings and revenue numbers for growth companies are coming down further than cyclicals. Jefferies recommends overweights in consumer discretionary and materials stocks, with DeSanctis saying the latter will benefit from China's reopening and a weaker dollar . Jefferies downgraded financials earlier this month after fourth quarter earnings came in worse than expected.