12 Small-Cap Stocks That Should Outperform as the Fed Cuts Rates

Small-cap stocks like Taylor Morrison Home should benefit from lower interest rates. (Courtesy Taylor Morrison)

Megacap tech stocks are no longer the only game in town: A small-cap comeback is underway.

The S&P Small Cap 600 and Russell 2000 indexes are up 6% and 7% in the past three months. While that still lags the nearly 9% gain for the Nasdaq 100, the Federal Reserve could give soon give small caps even more momentum. Barring a major surprise in the economy—such as shockingly strong job numbers or higher levels of inflation than expected—the central bank is likely to cut interest rates next month, and smaller companies tend to benefit in easing cycles.

“It’s the stealth summer of small caps,” said Francis Gannon, co-chief investment officer with Royce Investment Partners in an interview with Barron’s. “The broadening of the market rally is something investors have to pick up on.”

Gannon says small value stocks in particular should benefit from lower interest rates. Small cap companies tend to have more floating-rate debt than larger firms, so they benefit more directly from rate cuts. A stronger economy—thanks to stimulus and tax cuts resulting from the recently passed One Big Beautiful Bill in Washington—would help, too.

Along those lines, Gannon likes investment bank Evercore, which could get a continued boost from the recent comeback in the initial public offering market. He also likes industrials, such as welding tools maker ESAB and air conditioning equipment company AAON.

Consumer companies could also be beneficiaries of lower interest rates. Gannon said his firm also owns outdoor gear maker Yeti , a Barron’s stock pick from earlier this year, as well as Advance Auto Parts .

Bank of America also likes small-cap consumer companies, in part due to the Fed’s expected rate reductions.

“Cutting could potentially spur greater near-term outperformance than historically, given the increased sensitivity of small caps to interest rates,” Jill Carey Hall, equity & quant strategist for Bank of America Securities, wrote Wednesday.

She added that within small caps, the best-performing styles during Fed easing cycles have been value over growth and quality over risk. Hall and her team ran a screen of the Russell 2000 to find companies with attractive valuations, a recent history of paying dividends, and/or buying stock as well as healthy return on invested capital levels.

Several consumer discretionary stocks made the cut, including home builders Meritage Homes and Taylor Morrison Home as well as automotive-related companies Visteon, Asbury Automotive, and Group 1 Automotive. A couple of industrial companies, such as school bus maker Blue Bird and commercial truck dealer Rush Enterprises were also on the list.

It also doesn’t hurt that small cap stocks are cheaper than usual. The S&P 600 is trading at about 17 times earnings estimates for this year, nearly 30% below the broader S&P 500’s multiple. The S&P 600 has typically traded at only about a 25% discount.

“There is value to be found if you look below the surface,” said James Ragan, director of investment management and research at D.A. Davidson Wealth Management, in an interview with Barron’s.

Ragan added that the Russell 2000 has a higher concentration of financials, industrials, and healthcare stocks, noting that these are “three sectors that jump out as still having value.”

So investors should start playing some small ball. There’s more to the market than the Magnificent Seven, Broadcom , and Palantir.

Write to Paul R. La Monica at paul.lamonica@barrons.com