- Small-cap firms tend to be less stable than their larger peers, making them a higher-risk, higher-reward proposition for investors.
- The Fed's recent interest rate drop could help small-cap companies to be able to borrow money more easily, encouraging growth.
- There remains a wide range of risk within the small-cap space, so investors should look to fundamentals and important business developments as a guide for selecting investment targets.
Small-cap stocks faced a challenging environment for the last several years as inflation and high interest rates dampened lending opportunities. These companies—which are often in the early stages of development and lack stability—rely heavily on debt to fuel their growth.
Fortunately for the small-cap space, the Federal Reserve's September rate cut of 50 basis points is a welcome relief that should make borrowing more accessible. The fact that the Fed has signaled that additional rate cuts are likely in the months to come makes the coming economic environment look all the more appealing for small-cap companies.
In anticipation of lowered rates, the small-cap-focused Russell 2000 Index is up by more than a quarter in the last year. While the increasingly favorable rate landscape should be a boon to small-caps in general, some companies will benefit more than others. Investors looking to small-cap stocks should consider a range of fundamentals and analyst forecasts.
1. TZOO: Shift to Paid Model Has Driven Stock Rally
Travelzoo (NASDAQ:TZOO) provides a variety of websites and mobile apps relating to travel. The firm instituted a $40 annual membership fee at the start of 2024 after previously providing a similar set of services for free. While the shift to a fee-based subscription undoubtedly upset some members, the benefits for the company have so far dramatically outweighed the costs: the firm has yet to see a year-over-year drop in quarterly revenue and maintained more than 30 million members as of the end of the second quarter.
To be sure, Travelzoo has not yet completed its transition to a fee-based service. The company plans to monetize 95% of its existing member base through paid subscriptions by the beginning of 2025. This plan has fueled investor optimism in recent months, and Travelzoo shares have surged by almost 30% year-to-date and 130% in the last year. What's more, based on a forward P/E ratio of 12.6 and projected earnings growth of 17.5%, the company may still have plenty of room to grow.
2. FBRT: REIT With Strong Projected Growth
The residential real estate market broadly stands to benefit from reduced interest rates, as buyers have an easier time accessing mortgages, and sellers are more motivated to offload when they have the prospect of a relatively low mortgage rate as well. Franklin BSP Realty Trust (NYSE:FBRT) invests in residential mortgage pass-through securities, making it especially likely to benefit from a boost to home sales.
This real estate investment trust (REIT) has strong new commitments of well over $600 million in the most recent quarter, and cash on hand to be able to repurchase 3 million shares during that period as well. Its dividend payment history is strong and it has a dividend yield of 11.2%. Analysts project earnings to grow by more than 24% and see upside potential of more than 21%, too.
3. AURA: Positive Trial Results Fuel Optimism
Clinical-stage biotech firm Aura Biosciences (NASDAQ:AURA) has had a tumultuous year with a number of brief spikes in stock price, though shares are down about 5% in the last 12 months as of October 10. Still, analysts are widely optimistic about the company, as AURA shares enjoy a "buy" rating and a consensus price target of $21.67, more than 160% above current levels.
Driving this optimism is the company's recent positive results from its Phase 2 study of bel-sar, a treatment for certain types of ocular cancers. These results showed strong tumor control rates and vision preservation among patients, as well as a favorable safety profile.
Risk vs. Reward for Small-Cap Stocks
Small-cap stocks tend to be riskier investments than larger, well-established companies, but they can also offer the prospect of outsized returns when they succeed. Managing risk in the small-cap space also depends on the type of company, the industry and sector, and other factors. Biotechnology companies like Aura, for example, may remain unprofitable for a long period of time before seeing top- and bottom-line (and share price) spikes based on the success of a new drug treatment. This may make firms like this even more volatile than other small-cap companies.