After over two years of underperformance, it seems like small-cap stocks are finally poised to take off. This area of the stock market popped earlier in July as the Russell 2000 recorded its biggest gains since June 2020 in reaction to increased confidence in a Fed rate cut later this year.
Greg Tuorto, a portfolio manager at Goldman Sachs Asset Management, is confident that small caps will continue to explode in the coming months and sees now as the ideal time to invest.
However, not all small-cap stocks are created equally. “Selectivity in small-caps is key,” he said.
To get the best exposure to growth areas within the space, it’s not enough to just buy the Russell 2000 through an index fund. Because there is such a wide variety of small-cap companies, Tuorto believes investors have to do some digging to identify the best opportunities.
Don’t just buy the index
Tuorto emphasizes the importance of not passively buying into a small-cap index. In his opinion, this strategy will cause investors to miss out on growth opportunities, as it’s harder to lean into a particular trend or company in the small-cap space compared to large-caps.
For example, if large-cap investors are bullish on AI, they can easily get exposure to the trend through index funds, as the Big Tech companies make up an outsize proportion of the market.
“You’re not getting that if you go passive in small-caps. Some of the best opportunities are way, way down in cap. You’re buying two cents for every dollar you put in to get the unique areas of what you want to invest in,” Tuorto said. “Whereas you’re buying 15 cents of Nvidia if you buy the S&P 500.”
Instead, Tuorto carefully selects small-cap stocks for quality. He looks for characteristics such as profitability or prospective profitability, high levels of free cash flow, and strong management teams. It’s especially important for investors to do their due diligence on small caps, as some of these companies are still growing and haven’t achieved profitability yet.
That’s not necessarily a cause for alarm, according to Tuorto. “But you have to go into each one of these investment decisions knowing when that profitability will happen,” he added. Healthy small-cap companies have a clear path to profitability and reinvest cash back into their business to drive growth, he said.
The people who run these companies also matter. Strong management teams that understand the company’s financial condition and the overall competitive landscape are very important, Tuorto said. “We can sleep at night owning these companies and not worrying about where the dollars are gonna go if they have a mid-course correction and change the way they’re gonna start to spend things.”
Tuorto’s top small-cap picks
Below are Tuorto’s top six picks for high-quality small-cap companies with strong fundamentals and market caps under $10 billion. They are all constituents of the actively managed Goldman Sachs Small Cap Core Equity ETF (GSC).