Small-cap Stocks Rise After the Fed Cuts Interest Rates

When the U.S. Federal Reserve begins cutting interest rates, small-cap stocks often emerge as top performers. These companies, typically more reliant on variable-rate debt compared to their larger counterparts, tend to thrive as business confidence improves in a rate-cutting environment. As rates fall, small-cap stocks, which are frequently tied to cyclical industries, tend to outperform. This is because cyclical sectors generally perform better when the economy is on solid footing. Moreover, small companies primarily operate domestically, making them directly responsive to any growth in the U.S. economy that results from lower interest rates.

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Another factor working in favor of small caps is the significant ground they have to make up. The price-to-earnings (P/E) ratio of the Russell 2000, an index of small-cap companies, is currently 0.74 times that of the larger-cap Russell 1000, according to Bank of America’s quantitative strategist, Jill Carey Hall. Historically, these two indexes tend to trade at similar P/E ratios. This discount indicates a potential for stronger returns from small caps in the future. Hall predicts that over the next decade, the Russell 2000 could deliver annualized returns of 9%, compared to just 2% for the Russell 1000.

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However, investing in small-cap stocks can be challenging. Mick Rasmussen, who manages the Wasatch Long/Short Alpha Fund, has achieved exceptional results with small-cap investments. His fund has surged 32.5% over the past year, outperforming both competing funds, which gained 17.2%, and its benchmark index, which increased by 29%, according to data from Morningstar Direct. Over the last three years, Rasmussen’s fund has risen by about 51%, while the Russell 2000 has posted gains of around 2%.

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Rasmussen shares five key strategies for success in the small-cap space, along with examples of some of his favorite stocks.

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Quality Management: For small-cap companies, the quality of management plays a more significant role than it does in large-cap companies. Rasmussen emphasizes the importance of knowing management teams, a practice that gives him an edge over individual investors since he meets with many of them. “We often have known the management for many years before we initiate a position,” he notes.

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However, individual investors can also assess management quality by listening to earnings calls and evaluating management’s track record. Key factors to observe include the consistency of the company’s message and whether management delivers on its promises. Rasmussen looks for companies that perform well across different economic conditions and have strong performance metrics, such as high return on invested capital. One company in his portfolio that exemplifies excellent management is Ensign Group, a top holding of the fund. Ensign manages skilled nursing facilities and has successfully deployed capital to acquire and improve underperforming facilities, creating significant value in the process.

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Long-Term Growth: Rasmussen looks for companies with long-term growth potential that may be overlooked by the market. Sometimes, investors dismiss companies with high P/E ratios as overvalued. However, if a company can sustain double-digit earnings growth for an extended period, Rasmussen believes a high multiple is justified. He favors companies that can finance their growth with strong cash flow.

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UFP Technologies is one such example. The company manufactures components for advanced medical equipment, including surgery robots from Intuitive Surgical, a major client. UFP is also diversifying its customer base by producing components for other medical equipment. Novanta, another portfolio holding, is also positioned for long-term growth. The medical device maker is expected to increase earnings by 15% annually for the next decade by expanding into new product lines.

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Insider Ownership: Rasmussen values companies where management has significant ownership stakes, which aligns their interests with shareholders. He highlights two examples: Paylocity Holding, which provides payroll and human-resource software, and Xpel, a company that offers specialized protective coatings for automobiles. Insiders at both companies own more than 20% of the stock, ensuring they have a vested interest in the company’s success.

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Let Winners Run: Initially hired by Wasatch to analyze trading data, Rasmussen discovered that the firm often took profits too quickly. Today, Wasatch adopts a different approach by allowing winners to run, adding to positions when a company’s metrics—such as margins, cash flow, and earnings revisions—improve. A prime example is Guidewire Software, which offers software solutions to help insurance companies manage their operations.

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While the insurance industry has been slow to adopt cloud-based software, the shift is gradually happening, allowing insurers to integrate AI into their business models, making Guidewire’s services increasingly valuable.

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By applying these strategies, Rasmussen has achieved notable success in the small-cap space, demonstrating that with careful selection and analysis, small-cap stocks can offer significant opportunities for long-term growth, particularly during periods of economic recovery and Fed rate cuts.

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