The S&P 500 has bounced about 25 per cent off its October lows of last year. However, the powerful rally of just a few stocks is hiding weaknesses across the board – the five largest firms (Apple, Microsoft, Amazon, Alphabet and Nvidia) have rallied over 50 per cent year to date and contributed nearly all the US benchmark’s calendar-year performance.

Other parts of the market have struggled, and domestic and global small capitalisation equities have been belted over the past 18 months.

While it feels too early, now might be the time to consider some prudent purchases of small caps to supercharge portfolios into 2024.

Large cap stocks often take centre stage in the financial discourse, given the sheer number of their shareholders and customers. Frequently – and particularly when economic times are trending south – investors can crowd into the relative safety of these bigger stocks and their price-earnings multiple can become extremely stretched.

Since late 2021, the Australian small ordinaries index has unperformed the S&P/ASX 100 index by more than 15 per cent as the P/E multiple for small caps has fallen from about 19 to 15 times.

Small-cap stocks refer to companies with a relatively low market capitalisation – typically ranging from a few hundred million dollars in the domestic market to a few billion dollars in global markets. They present unique opportunities for investors due to their potential for substantial growth, diversification benefits and the potential to be acquired by larger players.

Given the price devaluation in the small-cap landscape, the potential offered by these stocks to rebound should not be overlooked when building portfolios.

Tougher conditions

The economic backdrop is clearly deteriorating further as central banks have responded to persistently higher inflation to lift interest rates way higher than most pundits would have predicted.

Most central banks are warning that rates are likely to stay restrictive for longer than recent cycles, and consumers and businesses have been increasingly vocal about the tougher conditions being experienced.

Businesses running higher gearing ratios are struggling as top-line revenues ease and wage pressures impose additional margin pressure along with the cost of funding. The repercussions for those that have made poor capital allocation decisions over recent years are likely to be even more severe as write-offs cascade through the profit and loss statement and reduce balance sheet flexibility.

So, a focus on quality will be critical in choosing what to buy.

Small-cap companies are generally more volatile than bigger companies as they are often relatively new to the public market, are growing quickly and requiring capital, and trading in their shares can be somewhat illiquid.

Additionally, investors have a lower confidence in their ability to access the capital markets when they need it. It is no surprise that when the IPO market dried up last year, and credit started being rationed, small-cap companies felt the brunt of the selling pressure.

Small-cap stocks are often overlooked or undervalued by institutional investors. Due to lower visibility and liquidity, these stocks can trade at a discount to their intrinsic value. They also have a relatively low correlation with large-cap stocks and the small ordinaries index provides a much broader diversification across sectors than the heavily concentrated S&P/ASX 100.

Smaller companies are often nimbler, allowing them to respond quickly to changing market conditions, adjust strategies and capitalise on emerging trends. As such, small-cap stocks are often attractive targets for larger companies seeking growth through mergers and acquisitions.

While short-term market volatility is expected as the extent of the economic downturn becomes clearer, it will become increasingly important for investors to focus on quality business models that can demonstrate resilience in navigating tougher economic times.

And while large-cap stocks will continue to dominate the headlines, it should pay dividends for investors to look for the hidden gems in the small-cap universe as they grow their way to becoming the future leaders.