Why there are still reasons to like small caps

The Russell 2000 (^RUT), which tracks small-cap stocks, has lagged the broader S&P 500 (^GSPC) index over the last 12 months.

Goldman Sachs Asset Management Portfolio Manager Greg Tuorto argues there are reasons to like small caps, such as potential IPO and M&A activity, earnings season, and some "unique thematic trends" in sectors such as retail and restaurants.

Overall Tuorto says small caps are "a very domestic asset class, very much driven directly by what's going on in the US economy. So the strength in the US economy should not be discounted in small caps."

Watch the video above to hear Tuorto explain why investing in small caps based on the benchmark indexes, like the Russell 2000, may not be the best way to go.

For more expert insight and the latest market action, click here to watch this full episode of Morning Brief.

This post was written by Stephanie Mikulich.

Video Transcript

- Let's take a look at small caps because once again, they're opening to the downside here today. And this follows what has been a downbeat week here for the group. It triggered by a hotter than expected inflation print out earlier this week making investors adjust their rate cut forecast, pushing off the likelihood that maybe we won't see a rate cut until the fall.

Well, going into this year, the group of stocks were poised to deliver potentially to the upside on hopes that the Fed was going to start easing. But that hasn't exactly panned out so far. So what is ahead, we want to talk about that with our next guest.

And joining us now here in studio, we want to bring in Greg Tuorto. He's with Goldman Sachs, here to break down everything that we have seen within the sector. Goldman Sachs Asset Management Portfolio Manager, I want to get your title in there, Greg. So let's talk about some of the downward pressure that we are seeing in small caps this week. Anything to be worried about or is there still a reason to like the group?

GREG TUORTO: I think that there are a lot of reasons to like the group. You have a nice earnings cycle starting. You have a lot of M&A and IPO undercurrents that will ignite animal spirits. And I also think that you have some pretty unique thematic trends in retail and restaurants and some parts of the technology cycle.

I think there are these kind of weekly, it seems, Fed tape bombs that come out and that's something we all have to be prepared for. But the underlying strength in the economy is something that always does drive small caps. It's a very domestic asset class. Very much driven directly by what's going on in the US economy. So the strength in the US economy should not be discounted in small caps.

BRAD SMITH: What do you make of consumers right now and how they play into the demand profile that we're going to hear from a lot of companies over the course of this earnings season as well?

GREG TUORTO: Yeah, it's been pretty uneven in terms of some of the companies that have come out. Some of the apparel companies have not-- have not done. And I mean, I think, if you look at the credit card data and some of the other alternative data that's out there, it's not as negative as what you've seen from some of the more recent results.

You have seen some interesting traffic pick up. But there's been some volatility around here because just because March was a really tough weather month and it wasn't just regional, it was around the country. I also think you had a time shift for Easter, which did change some merchandising plans and things at the retail level.

But I do think overall, you haven't seen a diminution in spending from the consumer. And I think it's one of those things that you will see it in a much more bifurcated way as the year goes on because the consumer has changed their-- changed their patterns. I think that they still want to travel. They still want experiences. I think that you know the apparel piece of it has to be something that's very much driven to them kind of in their gut, as opposed-- as opposed to just kind of replacing something that doesn't need to be replaced.

- Greg, what happens if the Fed doesn't cut rates this year?

GREG TUORTO: Well, I think if the Fed doesn't cut rates this year, I think what we'll see is kind of a GDP environment closer to 4%, which is probably a good place to invest in. I think you do sap some of the tailwinds for some of the more speculative assets.

I do think that small caps are often seen as a speculative asset class but we've had two tough years relative to large caps. So there's a valuation opportunity as well. So I think that may come into play as soon as we get kind of closer to the presidential election period. So I do think that it may take out one of the pillars that's underlying the small cap story but I don't think it takes most of them out.

BRAD SMITH: Is there a smart way that investors can aptly trade small caps beyond taking into-- or taking into portfolio account as well the unprofitable small caps that are out there?

GREG TUORTO: Yeah, it's a big issue for a lot of people. I think that if you buy the benchmark or you buy the indexes, I think what you find is there's a lot of stuff in those places you just don't want. There's a-- Russell 2000 has 1,900 companies and a good chunk of them don't have profits and probably never will. And some of them-- some of them, you know, some of the ones that are out there don't have profitability in their sights because they're spending on some really interesting things.

You also have some lower quality companies, the former SPACs of years past that are in there. And I think that if you-- if you follow a more quality-oriented approach as we do, I think that you find that the over indexation towards profitability is something that allows you to be kind of better than the benchmark over time.

- Greg, we talk a lot about the fact a lot of the momentum this year has been driven by AI. That was the fact also for 2023. And a lot of that has been attributed or I should say really benefited the large caps. Is there an AI trade for the small caps? Is that group going to benefit from AI as well?

GREG TUORTO: We think the picks and shovels piece of it will start to really manifest itself. It's been very singular kind of with the large caps out there. But I think as it gets broadened out and more-- and more of the large players get in there, you're going to need more chips. You're going to need companies like Onto Innovation, one of the companies in our portfolio that makes the advanced packaging process for high bandwidth memory, which you need for all these NVIDIA instances are out there.

There are other companies in the space that make cabling and other semiconductors, one that went public a couple of weeks ago that we really like and they're really tied along that same hype cycle curve that's out there that's growing very fast.

We think we'll start to see some software productization as well amongst these companies. And I think that there are many of these players that will be able to monetize this, especially in the enterprise. Because the enterprise, you know, they're not going to buy everything from the-- from the behemoths. They're going to want to do some things that are purpose built and really unique to what they do. And we see a number of opportunities out there in the software space.

BRAD SMITH: Greg, thanks so much for taking the time here with us today.

GREG TUORTO: Thanks for having me.

BRAD SMITH: Absolutely. Greg Tuorto who is the Goldman Sachs Asset Management Portfolio Manager here on Yahoo Finance.