3 Breakout Stocks That Should Be On Your Small-Cap Watchlist

Investing in small-cap companies can be a high-risk, high-reward proposition. These stocks offer the potential for significant growth, and small caps often emerge as momentum leaders when investors' risk appetites are rising. On the other hand, these smaller companies tend to lack the global exposure and diversity of their large-cap counterparts, and may also offer lower liquidity. However, with a little digging, it's possible to unearth some real hidden gems within the small-cap universe.

So far in 2023, the small-cap focused Russell 2000 iShares ETF (IWM) has been lagging the performance of its two well-known big-cap peers, the S&P 500 SPDR (SPY) and the Nasdaq QQQ Invesco ETF (QQQ). But with expectations for a U.S. recession fading by the day, supported by cooling inflation numbers, now might be a prudent time to add some exposure to fundamentally sound small-cap stocks.

Here's a look at three small-cap stocks which have not only outperformed the Russell 2000 this year, but have clocked genuinely impressive gains in their own right - and could be worth a look for investors at current levels.

Rocket Lab

Founded in 2006 by Peter Beck, Rocket Lab (RKLB) is an aerospace manufacturer and launch service provider, with dedicated launches for small satellites. The company's Electron is one of the smallest orbital rockets in the world, and can carry a payload of up to 500kgs to low Earth orbit. Rocket Lab has launched 39 of these rockets with a success rate of 97%, and has deployed over 170 satellites for customers in the commercial, civil, and defense sectors. The company - which currently commands a market cap of $3.15 billion - is now developing the larger Neutron rocket, which is expected to launch in 2024.

Shares of Rocket Lab have outperformed considerably in 2023. The stock is up 74.8% YTD, compared to an 11.4% gain for the broader IWM. The rise in RKLB's share price this year has been supported by the company's strong first-quarter results, along with key operational milestones that were achieved in the period.

Specifically, Rocket Lab reported a 34.9% rise in Q1 revenues to $54.9 million, which surpassed the consensus estimate. Although the company’s losses widened to $0.10 per share, compared to $0.06 per share in the year-ago period, that figure arrived in line with expectations. Notably, Rocket Lab's long-term borrowings remained almost unchanged from the beginning of the year at $100.7 million, though a marked 15.5% decline in cash, cash equivalents, and marketable securities from the beginning of the year may be a cause for concern.

Also of note during the first quarter, Rocket Lab secured a deal from NASA to launch its Starling Mission, along with deploying two satellites in space for NASA’s TROPICS mission. Further, it remains the only U.S. commercial small launch provider to successfully deliver satellites to orbit in 2023.

Consequently, analysts remain upbeat about Rocket Lab stock, which is slated to report its second-quarter results after the close tonight, Aug. 8. The consensus rating is a “Strong Buy,” with a mean target price of $9.73 - indicating upside potential of about 47.6% from current levels. 

Freshworks

Next up on our list is cloud-based customer engagement software company Freshworks (FRSH). Founded in 2010 by Girish Mathrubootham and Shan Krishnasamy, the California-based company competes directly with its much larger rival Salesforce (CRM). FRSH, which generated one of the largest tech IPOs in 2021 by raising over a billion dollars, currently commands a market cap of $6.32 billion.

In terms of share price performance, Freshworks has jumped 47.6% in 2023 so far - outperforming not only the IWM, but also the QQQ. That said, the stock hasn't quite bested key rival Salesforce, which is the top performing Dow Jones Industrial Average ($DOWI) component of the year with its rise of 62.9%.

Freshworks posted strong numbers for its second quarter last week. Revenues jumped by 19.5% from the previous year to $145.1 million, and surpassed the consensus estimate. Moreover, the company swung back to profitability, reporting an EPS of $0.07, compared to a loss of $0.06 per share in the year-ago period. Free cash flow also moved into positive territory, arriving at $18.1 million from an outflow of $10.2 million in the prior year.

Plus, Freshworks stepped into the exciting generative AI space with its customer service suite, “Freddy” - which brings together self-service bots, agent-led conversational messaging, and automated ticketing management into an all-in-one solution.

Notably, the company also increased its customer base in the second quarter. The number of customers contributing more than $5,000 in ARR stood at 19,105 at the end of the quarter, a yearly rise of 18%.

Analysts remain fairly optimistic about Freshworks stock, maintaining a consensus “Moderate Buy” rating with a mean target price of $22.37 - only about 3% above current levels. Out of 15 analysts covering the stock, 9 have a “Strong Buy” rating, 1 has a “Moderate Buy” rating, and 5 have a “Hold” rating. 

Upwork

We round out our list with the online freelancing platform Upwork (UPWK). The California-based company, which currently has a market cap of $1.95 billion, operates a platform that connects businesses with independent professionals who bid for projects.

Although Upwork hasn't gained quite as much ground as RKLB or FRSH in 2023, the stock is still up by a respectable 38.7% year-to-date - and is outpacing the IWM by a fairly wide margin - thanks in large part to a very recent earnings-related rally.

That big bull gap on the chart last week was prompted by an unexpectedly large profit at Upwork, as the company reported EPS of $0.10 - compared to a loss of $0.04 per share in the year-ago period, and against expectations for a breakeven quarter. Revenues rose by 7.5% yearly to $168.6 million, which likewise surpassed the consensus estimate of $162.71 million. 

Upwork reported net cash generation from its operating activities at $4.3 billion in the April-June period, up significantly from the previous year's outflow of $446 million. 
The company also lessened its long-term debt to $355.2 million at the end of the June quarter compared to $564.3 million at the beginning of the year. 

Although a slowdown in signing new enterprise clients remains a sore spot, the company improved its take rate - a key metric for platform companies - to 16.3% from 15% in the year-ago period.

Notably, Upwork is making moves to bolster the presence and usage of artificial intelligence (AI) in its platform, too. In July, the company launched its AI Services Hub, which brings clients and talented AI professionals together. To that end, the company announced a partnership with OpenAI, which connects the ChatGPT maker's customers with AI professionals on Upwork's platform.

Analysts remain generally optimistic about Upwork stock, even as the shares have run past Wall Street's mean target price of $12.27. Out of 10 analysts covering the stock, 6 have a “Strong Buy” rating, 1 has a “Moderate Buy” rating, and 3 have a “Hold” rating.

Final Takeaway

All of the aforementioned small-cap stocks appear to be solid performers at the current juncture, taking into account their robust fundamentals, recent share price movement, operational strength, future outlook, and analyst ratings.

Although Upwork is making visible moves to strengthen its presence further in its own domain, I remain more inclined to buy Freshworks and Rocket Lab now. This is not only because of Upwork's downside potential from current levels, but both Freshworks and Rocket Lab appear to have more substantial upside and growth potential relative to Upwork. Rocket Lab's fascinating partnership with NASA and presence in the commercial satellite launch space offer a unique draw for investors, while the sheer market size gap between Freshworks and its competitor Salesforce suggest there's ample headroom for future growth.

I believe if an investor is looking to consider adding small-cap stocks to their portfolio, all three of these names are worth a look. However, if deployable capital remains limited, Rocket Lab and Freshworks are the way to go - with the caveat that RKLB's imminent Q2 report will likely add some immediate event risk and volatility to the share price.