Small caps are poised to outperform in 2024. A value investor offers five stocks to buy

Published Sat, Dec 23 20237:01 AM ESTUpdated Tue, Jan 2 20244:53 PM EST

Small cap stocks could be poised for a breakout heading into 2024 even if the economy slips into a recession, according to Royce Investment Partners portfolio manager Miles Lewis. "We think a recession or a slow down and a lot of the bad news people are worried about is largely priced into small caps," Lewis told CNBC. Stocks are on pace to end the year higher as traders bet on lower interest rates in 2024. The Federal Reserve left benchmark interest rates unchanged at the central bank's December meeting, and Fed policymakers' "dot plot" forecast three rate cuts next year. The news helped lift all three major indexes to 52-week highs on Dec. 13, with the Dow Jones Industrial Average closing at an all-time high. Lewis said he thinks that the stage is set for small caps to regain their footing next year. For context, the Russell 2000 index, often touted as a barometer of the economy's true health, has gained roughly 13% in 2023. The S & P 500, meanwhile, has climbed nearly 25% from the start of the year. .RUT YTD mountain The Russell 2000 index. "We believe that we are at the end of one of these cycles where large is leading small," Lewis said. He pinned his optimism to factor such as an overconcentration in the "Magnificent Seven" stocks, attractive small-cap valuations as well as the current period of low returns, which could result in "a slightly higher return environment from this point forward." "Up until very recently, you've had a period of very low returns," he said. "But we still think all the pieces are in place for for a big rally in the asset class," he said. Here's a look at Lewis' top five stocks for 2024. Arkansas-based regional bank Home BancShares is one of Lewis' top picks thanks to expected margin expansion next year as well as a reacceleration of long-term growth trends as interest rates fall. The stock is up roughly 12% so far in 2023. Lewis also highlighted the regional bank's expansion throughout Texas and Florida, which he says are "attractive markets." HOMB YTD mountain Home BancShares stock "It is a bank that for us checks every single box of what we look for," Lewis said. "It's got a fortress balance sheet, and I don't use that term lightly. They have more capital than almost any other regional bank. They had loan loss reserves that are at 2% of their loans [and] the typical bank is around one. That doesn't sound like a lot, but it's a huge number." Lewis touted distressed automotive parts company Advance Auto Parts as a "recession resistant business" that could grow in a weaker macroeconomic environment as consumers make needs-based purchases. The stock has slumped about 58% from the start of the year. AAP YTD mountain Advance Auto Parts stock. "We think of this as a kind of a bad house, a fixer upper, but in a really good neighborhood," Lewis said. "Everything that could go wrong for this company in last probably six months or so has gone wrong," he said, citing its decision to cut its dividend and having to slash its financial forecasts twice as examples. Still, Lewis expects the company's shares will rise as margins improve and the underlying core business remains strong. Payment processing company Repay Holdings , which has gained roughly 2% from the start of 2023, is another pick. The company remains strong despite waning sentiment for fintech stocks, Lewis said, adding it is inaccurately perceived as having large exposure to consumer credit risk. RPAY YTD mountain Repay Holdings stock. "As value investors, we don't get to own companies that have double-digit top line growth very often, because those multiples are usually pretty expensive," Lewis said. "But here, you get a great business with some structural tailwinds, some secular tailwinds that's going to grow very nicely, at less than nine times earnings because it was just kind of out of favor." Aircraft lessor Air Lease is "well positioned" thanks to a fleet of narrow body planes that are experiencing an uptick in demand, according to Lewis. The stock has added about 10% so far in 2023, and Lewis said the lag in the share price is due to the rapid increase in interest rates in 2023, which compressed margins. AL YTD mountain Air Lease stock. "We think this reverses as new leases come on at higher yields, some leases reset higher, and funding costs stabilize [or] decline," Lewis said. "At highest level, [Air Lease is a] play on a rising global middle class and increased air travel." Also on Lewis' list is digital media company Ziff Davis , which he noted benefits from repeat customers and growing ad revenue. He expects the company is well positioned to grow through mergers and acquisitions, which Ziff Davis has done little of in the post-pandemic era. ZD YTD mountain Ziff Davis stock. "We expect a pick up in M & A in 2024, as seller expectations get reset," he said. "ZD has a large cash pile ($660mm) to put to work." Correction: A table in an earlier version of this story misstated one of Royce Investment Partners' picks. It should have been Ziff Davis, as indicated in the text.