US stock market style "big to small" in progress! Morgan Stanley focuses on these small-cap stocks

Zhitong
2024.10.22 04:26
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Morgan Stanley recently released a small-cap stock research report, listing its top picks for US small-cap stocks. Since 2022, small-cap stocks have underperformed under the pressure of the Federal Reserve's interest rate hikes. However, due to expectations of rate cuts and an economic "soft landing" in the near future, the Russell 2000 index has risen by about 10%. Morgan Stanley has upgraded its rating on small-cap stocks from "sell" to "neutral", and pointed out that small-cap stock returns often reach as high as 25% after presidential elections

According to the financial news app Zhitong Finance, Wall Street financial giant Morgan Stanley (referred to as "Morgan Stanley" below) recently released a small-cap stock research report and listed its preferred small-cap stocks in the US stock market. This group has been sluggish since 2022 under the pressure of aggressive rate hikes by the Federal Reserve and long-term high interest rates. However, they have recently benefited from the start of the Fed's rate cut cycle and the broader stock market rotation towards small and mid-cap stocks driven by expectations of a "soft landing" in the US economy. However, the Morgan Stanley analysis team stated that before being completely bullish on small-cap stocks in the US, the institution is still waiting for some macro-level evidence to support the bullish logic for small-cap stocks.

It is understood that the benchmark for US small-cap stocks, the Russell 2000 Index, has risen by about 10% since the second half of the year, almost on par with the S&P 500 Index. The Russell 2000 Index had been at the bottom for the past two years. ETFs tracking US small-cap stocks, such as IWM, VB, IJR, and SCHA, which are anchored in small-cap stocks, have seen a significant increase in value since the second half of the year. The assets under management of these ETFs have been continuously rising due to funds switching to the small and mid-cap sector.

In addition to the valuation recovery brought about by the new round of Fed rate cuts and expectations of a "soft landing" in the US, part of the reason is the upward momentum brought about by the US presidential election.

Expectations of Trump maintaining low corporate taxes and slowing down the scale of corporate regulation, combined with expectations of Fed rate cuts, have boosted the stock prices of small businesses. Analysts generally believe that these companies are benefiting more from greater confidence in US economic growth.

In a report released on Monday Eastern Time by Morgan Stanley, the absolute returns of US small-cap stocks in the 12 months following a US presidential election often reach as high as 25%, far outperforming the benchmark for large-cap stocks, the S&P 500 Index, by about 6%.

Following the news of a surge in non-farm payrolls in September and an unexpected 50 basis point rate cut by the Fed last month, Morgan Stanley's analysis team recently upgraded their rating on small-cap stocks from "sell" to "neutral", after maintaining the negative rating of "sell" for 3 years. In the research report, Morgan Stanley stated, "If we need to maintain an optimistic bullish attitude towards small-cap stocks as a whole, leading macroeconomic indicators may need to show that US economic growth will accelerate significantly." This latest view is consistent with Morgan Stanley's US stock research report released on October 16.

The Morgan Stanley analysis team stated that further upgrading the view on small-cap stocks would require an upward revision of GDP for 2025 and 2026, as well as further improvement in leading survey indicators such as ISM services and manufacturing PMI, continued improvement in the health of US consumers, and a significant upward revision in the overall earnings per share of small-cap stock constituents.

With the start of the Fed rate cut cycle, the market's shift from "large to small" investment style switch may become more pronounced

Typically, when the Fed announces the start of a rate cut cycle, small-cap stocks often outperform large-cap stocks in the short to medium term, as small businesses are more sensitive to floating interest rates due to their smaller balance sheet size and limited operating scale Assuming the Fed's rate cut cycle officially begins and the "soft landing" of the U.S. economy becomes a reality, the upward trend of U.S. stocks is very likely to rotate to small and medium-cap stocks that have suffered long-term price declines since 2022. These stocks are theoretically extremely sensitive to interest rate expectations and economic growth expectations, and even a slight rate cut is expected to boost their battered stock prices and valuations.

The seven major tech giants in the U.S. stock market, known as the "Magnificent 7" with high weights in the S&P 500 index, including Apple, Microsoft, Google, Tesla, NVIDIA, Amazon, and Meta Platforms, are the core driving force behind the continuous record highs of the S&P 500 index.

Looking at the entire U.S. stock market, the core logic behind the comprehensive outperformance of the seven major tech giants over value stocks and a wide range of small and medium-cap stocks since 2023 lies in the global AI boom background, the uncertain Fed rate cut expectations, occasional major retreats in rate cut expectations, and the not-so-strong growth trend of the U.S. economy, which, although occasionally falling short of expectations, is not overly weak to fall into an economic recession. In this trading scenario, the seven major tech giants have become a "safe haven" for global funds facing uncertain rate cut expectations and slowing economic growth, thanks to their unparalleled AI revenue scale, solid fundamentals, strong free cash flow reserves, and continuously expanding stock buyback programs.

However, Wall Street strategists now generally believe that under the macro background of the Fed's rate cut, the performance of small and medium-cap stocks may far outperform the seven major tech giants and broad market stocks. The main logic is that small and medium-cap stocks, especially small-cap stocks, are often very sensitive to the benchmark interest rates set by the Fed. They heavily rely on floating rate loans, so under the backdrop of a major Fed rate cut, the long-standing debt pressure on them is significantly reduced, potentially leading to higher profit margins and stock valuations.

Therefore, with the FOMC dot plot indicating that the Fed may cut rates by up to 200 basis points by the end of next year, the classic rotation rally of small and medium-cap stocks or the trend of profit recovery in small and medium-cap stocks may fully emerge, driving funds towards small and medium-cap stocks that benefit from the rate cut cycle and have very cheap stock prices and valuations, rather than the tech giants whose valuations are at historical highs. Investors will become "comparative shoppers" in the general sense, also known as "comparing three products".

The following list of individual stocks is Morgan Stanley's analysis team's industry-classified "preferred small-cap stock list" of U.S. stocks. Among them are well-known companies such as American Airlines (AAL.US) and U.S. Steel (X.US), both of which were leaders in their respective industries and were part of the large-cap stock category, but in recent years, their stock prices have remained low, with current market values of less than $10 billion.

Mks Instruments, a semiconductor equipment company, is also a popular stock in the U.S. stock market. It is a company focused on providing process control equipment, instruments, and solutions for high-end manufacturing fields such as chip manufacturing, serving areas such as chip manufacturing, industrial technology, optics, and communications. The company's stock price has been soaring since 2023, with an increase of over 100% from October 2023 to July this year. However, the stock price has since experienced a significant pullback due to the yen carry trade unwinding and pessimism surrounding the unclear prospects of AI monetization However, what surprised investors is that the stock is not part of the S&P 500 index constituents, but belongs to small-cap stocks.

Here is Morgan Stanley's "Preferred Small-Cap Stock List," with corresponding US stock codes in parentheses:

Healthcare:

LifeStance Health Group (LFST)

10x Genomics (TXG)

Axsome Therapeutics (AXSM)

Bicara Therapeutics (BCAX)

Biohaven (BHVN)

CG Oncology (CGON)

Dyne Therapeutics (DYN)

Legend Biotech (LEGN)

Rhythm Pharmaceuticals (RYTM)

Structure Therapeutics (GPCR)

Viking Therapeutics (VKTX)

Industrials:

Bloom Energy (BE)

Embraer (ERJ)

Kornit Digital (KRNT)

RBC Bearings (RBC)

Alaska Air (ALK)

American Airlines (AAL)

ArcBest (ARC)

Knight-Swift Transportation (KNX)

Non-Essential Consumer Goods:

BorgWarner (BWA)

Chewy (CHWY)

Group 1 Automotive (GPI)

Valvoline (VVV)

Hasbro (NHAS)

Planet Fitness (PLNT)

Financials:

Prosperity Bancshares (PB)

Bridge Investment (BRDG)

Evercore (EVR)

Lazard (LAZ)

High-Tech and Information Technology:

Mks Instruments (MKSI)

Blackline (BL)

Unity Software (U)

Vertex (VERX)

Materials:

Alcoa Corporation (AA)

Summit Materials (SUM)

United States Steel Corporation (X)

Real Estate:

Agree Realty (ADC)

American Healthcare REIT (AHR)

Energy:

Antero Resources (AR)