a Cheap Small-Cap Sector Set to Bounce

• Growth stocks have struggled this year, but that has encouraged some investors to ‘buy the dip’.
• Federated Hermes portfolio manager Jordan Stuart said pockets of the market now look undervalued.
• “Small-cap stocks have been crushed, but now the downside is already priced in,” he told Insider.

It’s been a rough year for growth stocks, with small-caps particularly feeling the brunt of Ukraine war volatility and interest rate rises.

But a stock picker for Federated Hermes, which manages $646 billion, believes this has created opportunities for investors to ‘buy the dip’ – and highlighted one downtrodden sector that now has particularly attractive valuations.

“Growth stocks have been annihilated this year – just look at Cathie Wood’s funds,” Jordan Stuart, a portfolio manager for the firm’s Kaufmann Fund, told Insider in a recent interview. “Small-caps have also been crushed, but now the downside is priced in.”

The Russell 2000, an index of small-cap stocks, has fallen by 15% this year, compared with a 2.4% gain in the big-cap S&P 500 index.

Stuart explained why he’s expecting some small-cap stocks – typically defined as companies with a market capitalization below $2 billion – to rebound over the next year. He also shared why he’s particularly bullish on the biotech sector. Wood’s flagship ARK Invest fund has fared even worse, having lost 50% in value. 

Investing outlook

There are two possible outcomes for growth stocks from here, Stuart said — and he’s optimistic about which will unfold.

“Defensive value stocks have obviously held up better than growth so far,” he said. “I don’t think value’s going to come crashing down, which suggests there’s potential that growth stocks will rebound back to the level that value stocks are at now.”

Stuart likes innovative small-caps in industries like healthcare, software, and technology, because they’re less susceptible to cyclical economic trends due to their potential for long-term growth.

“Those sectors still aren’t immune from any of this slowdown, but their long-term growth prospects will outweigh some of the downturn we’re experiencing right now,” he said.

That being said, interest rate rises could hamper small-caps’ growth prospects. Higher interest rates make it more expensive to borrow money, disrupting smaller companies’ balance sheets.

Stocks to buy

Stuart believes there are significant investing opportunities in the biotech sector, with small-cap stocks looking particularly undervalued right now.

“Biotech stocks have really paid the price for rising interest rates,” he told Insider. “But they could rebound very fast over the next 12 months, potentially erasing this year’s 27% downturn.”

Many of these companies are developing technology that combats the spread of coronavirus – and Stuart believes that some are well-positioned to soon make a major breakthrough.

“One of these firms could discover a vaccine that just annihilates the virus,” he said. “If that happens, nobody will care about interest rates – these sorts of stocks will skyrocket.”

iShares’ Biotechnology ETF, SPDR’s S&P Biotech ETF, and Ark’s Genomic Revolution ETF are the three largest publicly-listed biotech funds by assets under management.