17 'unfairly punished' stocks to buy since history says a market leadership shift is near

Small- and mid-sized stocks are primed for a breakout, a strategy chief says.Spencer Platt / Getty Images

• Small- and mid-cap stocks have logged solid, if not strong, returns for much of 2024.
• However, the group has been left in the dust by large caps, which continue to thrive.

Smaller stocks have done well, but investors are still giving them the little-brother treatment.

The small- and mid-cap-focused S&P 600 and S&P 400 indexes have both more than doubled their typical trailing 12-month returns in the last year, according to BMO Capital Markets.

However, the large-cap-heavy S&P 500 has performed even better. It's up around 34% in the last 12 months, which is about 10 percentage points better than each of its smaller counterparts.

So-called SMID caps seemed poised to take the baton from large caps over the summer. However, a head-turning rally in July — which was one of the cohort's best months in decades on a relative basis, according to BMO — soon fizzled.

Although smaller stocks found their groove again later in the third quarter, they didn't keep pace with large caps, wrote Brian Belski, the chief investment strategist at BMO, in a recent note.

Even so, BMO remains convinced that small- and mid-cap stocks will lead their larger peers since their performance and valuations are out of sync with their underlying fundamentals.

"We continue to believe that these stocks have been unfairly punished (or ignored) given what we have viewed as a mismatch between the fundamental underpinnings and the relative performance of the group, and nothing has changed in that regard," Belski wrote.

Central to BMO's bullish thesis for smaller stocks are the group's eye-grabbing relative performance and valuations.

Down-cap equities are significantly oversold versus large caps after lagging for most of the last half-decade. The S&P 600 and S&P 400 are trading one standard deviation below the S&P 500, Belski noted, even though they've risen roughly 10% from their early-August lows.

Historically, those indexes have mounted a major rebound after trailing by so much for so long.

"Relative underperformance remains quite extreme compared to historical standards, and this sort of weakness has typically been followed by swift rebounds over the past 30 years," Belski wrote. "Therefore, we continue to advise investors to increase exposure to this area since we believe it is only a matter of time before the fortunes of this group take a turn for the better."

Small- and mid-caps are also fairly valued relative to their own histories.

BMO analyzed a variety of valuation metrics and found that the S&P 600 is trading below its 20-year average level, while the mid-cap-oriented S&P 400 is just above it. Still, the latter looks like a bargain compared to the S&P 500, which is two standard deviations above its average.

"Relative valuation for SMID is at abnormally low levels for both groups with the latest readings at roughly minus two standard deviations compared to the 20-year average," Belski wrote. "These abnormal discounts more than reflect the group's earnings struggles, and [we] believe they offer compelling value for investors looking to add exposure."

Cheap valuations are far from the only catalyst for smaller stocks.

SMID-cap earnings, which were a drag for years, have improved significantly in recent months, Belski wrote. The strategy chief is encouraged by both the cohort's forward earnings estimates and their profit outlook relative to large caps.

"We believe peak pessimism is in place, making a rebound even more likely, and recent trends have begun to show some improvement," Belski wrote.

Interest rate cuts are another key tailwind, as they tend to disproportionately benefit smaller companies. SMID caps typically soar relative to large caps during monetary easing cycles, Belski wrote. He found that the S&P 600 and S&P 400 advance by an average of 12.8% and 10.7%, respectively, in the first year of cuts, versus a more modest 6.7% gain for the S&P 500.

"Average returns jump to over 20% for both groups when Fed rate cuts were able to prolong economic growth and avoid recession — which has quickly become the consensus expectation in the current environment," Belski wrote.

After a series of false starts, Belski believes smaller stocks will finally lead the market higher.

The strategy chief listed the 17 outperform-rated stocks in BMO's US SMID-cap model portfolio. Below is each firm, along with its ticker, market capitalization, and price-to-earnings (P/E) ratio.