Earnings Growth Outlook, Potential Rate Cuts Could Finally Boost Small Cap Stocks

It has been a tough go for the small-cap-focused Russell 2000 Index (NYSE:IWM). The Index declined 3.3% during the second quarter, while the S&P 500 saw quarterly gains of nearly 4%. Large cap outperformance can largely be attributed to the continued hype around artificial intelligence (AI), cooling inflation, reasonable U.S. economic growth and the impressive resilience of the ‘Magnificent Seven’: Alphabet (NASDAQ:GOOG), Apple (NASDAQ:AAPL), Amazon (NASDAQ:AMZN), Meta (NASDAQ:META), Microsoft (NASDAQ:MSFT), Nvidia (NASDAQ:NVDA), and Tesla (NASDAQ:TSLA).

Despite the heavy focus on larger-cap stocks, small-caps could present a big opportunity for patient long-term investors. On a comparative basis, small-caps are the cheapest relative to large-cap stocks in 25 years. At the same time, the small-cap earnings growth outlook for 2024 is projected to be higher than large-cap stocks. While the long-awaited interest rate cuts by the Federal Reserve could help boost smaller stocks in the short term, big investors are excited about the valuation and earnings growth prospects.

Institutional Investors Continue to Hold Bullish Outlook for Small-Cap Stocks 

In a recent Q&A, Royce Investment Partners’ portfolio manager, Chuck Royce, and co-CIO, Francis Gannon, shared their thoughts on the current state of the small-cap market. In the July 2024 article, Royce and Gannon shared their surprise at the lack of performance of the Russell 2000 Index during Q2 2024. However, the second quarter has not shaken their long-term bullish stance on smaller market cap stocks.

Chuck Royce highlighted the historical valuation level of small-caps as a key factor: “…small-caps continue to be far more attractively valued than their larger peers, based on our preferred index valuation metric of EV/EBIT or enterprise value over earnings before interest & taxes.”

To investors that may have doubts regarding the long-term prospects of small-caps, Francis Gannon argued: “The Russell 2000 finished June with a near-record number of companies with no earnings, but earnings acceleration is expected to be higher for small-cap companies than for large-cap businesses through the end of 2024.”

Mr. Gannon went on to discuss that active managers (stock pickers) have done well with small-caps over the past several years and that a focus on companies showing earnings growth continue to be a promising strategy moving forward.

Echoing similar sentiments as Royce, William Muggia, the president of Westfield Capital Management (subadvisor to the Harbor Small Cap Growth Fund), said higher earnings estimates and the historical undervalued state of smaller stocks gives him reasons to be bullish. “I can’t tell you we are at the absolute bottom. But it sure smells like it,” stated Mr. Muggia in a report to Barron’s.

ASUR: A Small-Cap with Strong Earnings Growth

In the spirit of Royce Investment Partners’ preference for small-caps with a history of growing earnings, Asure Software (NASDAQ:ASUR) is one stock that may be within their wheelhouse. The Texas-based human capital management software solutions provider has continued producing strong top and bottom-line growth since the 2020 pandemic.

During Q1 2024, Asure reported total revenue (excluding ERTC) of $30.7 million, which translated to year-over-year growth of 10%. For the full year 2024, management has issued guidance that estimates revenue between $125 million to $129 million on an adjusted EBITDA range of $25 million to $27 million.

Considering Asure’s core businesses produced total revenue (excluding ERTC) of $101 million during full-year 2023, the guidance suggests revenues could expand a healthy 26% through 2024.

Despite the revenue and earnings growth figures, Asure trades at a discount relative to some of its industry peers. As of March 2024, Asure traded at an enterprise value-to-revenue of 1.3x, compared to an average of 5.7x among Paycor (NASDAQ:PYCR), ADP (NASDAQ:ADP), Paycom (NYSE:PAYC), Paylocity (NASDAQ:PCTY) and Paychex (NASDAQ:PAYX). If Asure were able to reach a similar EV/Revenue valuation of the listed peers above, the implied share price for the small-cap HCM company would range from $20 to $37 per share, showing lots of potential room for growth.

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