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Small-caps were a hot stock pick a year ago. Now Goldman Sachs warns of trouble ahead

February 7, 2022, 10:41 AM UTC

One of the breakout stars of so-called reopening trade from late 2020 was the small-cap stock. Analyst after analyst saw these cheaply priced companies as engines for solid returns, and investors heeded the call, driving up the Russell 2000 to impressive gains in the second half of 2020 and early last year.

You may remember a few of these high-fliers. Names like cinema chain AMC Entertainment, and of course GameStop, generated tremendous buzz during the meme stock rally of early 2021, and beyond.

But the overall small-fry stock trade fizzled by Q2 of 2021 as inflation began to bite into corporate margins and as the Federal Reserve Bank began to signal its intention to slow down its asset purchases (“tapering,” in market parlance) and, following that, to raise the prime lending rate (tightening).

Over the past 12 months, Goldman Sachs reports, the Russell 2000 has plunged by 7%. Compare that with the S&P 500: It notched an impressive +19% in the same period. It’s one of the biggest divergences between the two indexes in a generation.

Last week, small-caps had their best run of the year, finishing in the green for the week. Could this be a sign of a rally in the making?

Not so fast, says Goldman’s David J. Kostin.

“Client conversations have recently focused on the dramatic underperformance of the Russell 2000 small-cap index,” writes the investment bank’s chief U.S. equity strategist in a client note from Friday. “Small-cap firms generally have weaker balance sheets, lower profit margins, and less market power, all of which make them highly sensitive to economic growth environments.”

Unprofitable small-caps

In other words, storm clouds are swirling over small-cap stocks. Labor costs are skyrocketing, as is inflation. That will put pressure on profits. At the same time, economic growth is slowing, a potential drag on the firms’ top line. 

The Fed is no friend either. The central bank plans to raise rates this year, which will drive up debt-servicing costs for unprofitable companies. And there are plenty of those firms gushing red in the Russell 2000. By Goldman’s count, “a near-record 32% of Russell 2000 stocks are expected to generate losses in 2022.”

“Looking ahead,” Kostin continues, “tightening financial conditions, slowing growth, and a flattening yield curve should all pressure Russell 2000 returns relative to the S&P 500.”

Goldman, though, is not writing off the entire universe of small-caps. Those small-caps that can demonstrate strong growth, high profit margins, and “undemanding” valuations are candidates to outperform the rest of the Russell 2000. Conversely, a general small-cap–focused ETF could drag down an investor’s portfolio.

Which small-caps are ripe for decent returns? Goldman gives the following names:

Marathon Digital Holdings (MARA); Northern Oil and Gas (NOG); Murphy Oil (MUR); Riot Blockchain (RIOT); Federated Hermes (FHI); Crocs (CROX); Focus Financial Partners (FOCS); Herc Holdings (HRI); Tivity Health (TVTY), and Sun Country Airlines (SNCY).

Check out this Fortune must-read: “Why Wall Street thinks the metaverse will be worth trillions”