In this article, we will look at the 8 Most Profitable Small-Cap Stocks To Invest In.

Fed’s rate cuts have been all the rage recently, and they may have set the stage for a strong Q4. On September 27, Jay Woods, chief global strategist at Freedom Capital Markets and long-term member of the New York Stock Exchange, filled in for Michael Reinking on Market Storylines inside the Icehouse Podcast feed to discuss the Fed rate cuts and outlook for Q4 2024. He said the market has absorbed rate cuts very positively, with the S&P 500 reaching new all-time highs.

He also said that historically, the fourth quarter tends to perform well when markets hit new highs in September. This holds especially true in election years. With the stock market now in Q4, Woods highlighted that certain sectors, like utilities, real estate, and industrials, led the market in Q3. Technology, however, lagged in Q3 and might make a comeback in Q4.

Small-Cap Stocks Set for Major Gains

We recently discussed the potential future outlook of small-cap stocks in an article on 8 Penny Stocks with Biggest Upside Potential According to Analysts. Here is an excerpt from the article:

On October 4, Eduardo Lecubarri, managing director and global head of small and mid-cap equity strategy at J.P. Morgan, talked about the potential of investing in small to mid-cap stocks in an interview on CNBC. He breaks down the opportunities in the space, while shedding light on how to pick the right stocks in what he calls a “generational opportunity.” He says that we are living in a tricky world where the opportunity to invest lies in realizing the hidden value in the small and mid-cap sectors and picking the right stocks instead of investing broadly.

He claims that times have changed, with small and mid-caps stocks going from being not the most suitable investment in previous years to paving the way for the biggest opportunity in the sector in the past 2-3 decades. He further elaborated and said that the opportunity of picking a small to mid-cap versus large-cap stock is bigger now than he has ever seen in the past 30 years. This generational opportunity, however, is not without its pitfalls for those who fail to make the right picks.

Pricing power and high-margin businesses can be suitable indicators of the right small to mid-cap stocks to invest in, according to Lecubarri. The need to find value and invest in stocks with achievable earnings growth expectations also holds pivotal value in making the right choices. While 2022 to 2023 was the time to stay away from small to mid-cap stocks, Eduardo Lecubarri says that times have changed with the stabilizing economy.

Analysts are thus bullish on the potential of small caps, with the general expectation that they might outperform large caps in a slowing economy. However, with the US Presidential elections just around the corner, the market environment is posing some choppiness, which demands caution from investors.

Why Are Analysts Keeping an Eye on Small Caps?

On October 4, Larry Adam, chief investment officer at Raymond James, joins CNBC’s ‘The Exchange’ to discuss why he’s keeping an eye on small caps in certain sectors. He said that lower interest rates are expected to benefit small caps, especially the Russell 2000, thus promoting the perspective that the bull market will continue. With the risk of recession now overruled, the economy is moving closer to soft landing. Adam concludes that with the Fed continuing to lower interest rates, small cap stocks will be better positioned to meet their financial needs.

These stocks get around 56% of their financing from the short end of the yield curve, which refers to the short-term interest rate on the yield curve. This typically represents the yields on bonds with shorter maturities, such as 2-year or 5-year Treasury notes. Large-cap companies, in contrast, get only 26% of their financing from these short ends of the curve. Small-caps are thus in a better position to benefit.

The Fed is anticipated to cut rates two times in 2024 and another four times in 2025, reflecting a positive market for small-caps. These stocks have also outperformed large caps. When taken in a historical context, circumstances help small caps significantly more than the rest of the market whenever the economy goes towards a soft landing.

Small Caps and a Late Cycle Economy

On October 11, CNBC’s Mike Santoli and Northwestern Mutuals’ Brent Schutte, appeared on ‘Power Lunch.’ He said that there is a delicate balancing act that the Fed has to navigate, and historically, haven’t done a good job doing so. They tend to wait till the labor market shows signs of weakening, and unfortunately, it tends to trend and then its too late. He says that this time is a little different because there is inflation and the embers are burning, and this is a late cycle economy.

With the late cycle phase of the economy, concerns about the shift from large cap stocks to small caps is rising. Schutte says that such concerns were also heard in 1999 and 2000, years that had a similar market. The market became very narrow because the economy became very narrow.

He says that one way or the other, for investors more interested in returns over a three to five year period, small and mid caps stocks, irrespective of whether a soft landing appears or not, offer value because they have been priced, somewhat, for a recession.

With that context for small and mid caps, let’s look at the 8 most profitable small-caps to invest in.

Our Methodology

For this article, we used Finviz and Yahoo Finance stock screeners plus online rankings to compile an initial list of the 60 largest small-caps. We define small-cap stock to be those with market caps between $300 million and around $2 billion. Please note that the market caps were recorded on 17th October, 2024. From that list, we narrowed our choices to 8 stocks with positive TTM net income and 5-year net income growth informed by reputable sources, including SeekingAlpha and Yahoo Finance. We then sorted the stocks in ascending order of their hedge fund sentiment, which was taken from our 912 elite hedge funds database as of Q2 of 2024.

Why do we care about what hedge funds do? The reason is simple: our research has shown that we can outperform the market by imitating the top stock picks of the best hedge funds. Our quarterly newsletter’s strategy selects 14 small-cap and large-cap stocks every quarter and has returned 275% since May 2014, beating its benchmark by 150 percentage points (see more details here).

8 Most Profitable Small-Cap Stocks To Invest In

8. Sixth Street Specialty Lending Inc. (NYSE:TSLX)

Market Cap: $1.94 billion

5-year Net Income Growth: 8.83%

TTM Net Income: $210.9 million 

Number of Hedge Fund Holders as of Q2 2024: 12

Sixth Street Specialty Lending (NYSE:TSLX) is a specialty finance company that lends to middle-market companies, generating current income primarily in United States-domiciled middle-market companies. It does so through direct originations of senior secured loans and, less commonly, originations of mezzanine and unsecured loans and investments in equity securities, corporate bonds, and other instruments.

Its funding and commitments in Q2 2024 reached $164 million and $231 million, respectively, across five existing and eight new portfolio companies. The company is continually benefiting from a size and scale of six used capital bases, participating in several large-cap transactions in the quarter. This highlights the power of the platform, allowing it to toggle between small and large-cap opportunities depending on where the risk-reward and relative value are appropriate for its shareholders.

In addition, Sixth Street Specialty Lending (NYSE:TSLX) has maintained a steady deployment pace, diversifying its portfolio through higher competition periods for lower deal activity. It is continuously sourcing new investment opportunities, with 83% of total funding of new portfolio companies.

The company’s largest funding this quarter was in a senior secured credit facility to merit software holdings, reflecting its core competency in the middle market. It is positioned to be a solutions provider for significant companies, with its expertise in niche markets allowing it to move quickly and with certainty to finance its best-in-class SMB vertical market software businesses. It ranks eighth on our list of the 8 most profitable small-cap stocks to invest in.

7. Enterprise Financial Services Corporation (NASDAQ:EFSC)

Market Cap: $1.99 billion 

5-year Net Income Growth: 16.77%

TTM Net Income: $171.29 million 

Number of Hedge Fund Holders as of Q2 2024: 13

Enterprise Financial Services Corp (NASDAQ:EFSC) is a financial holding company for Enterprise Bank & Trust, a full-service financial institution that offers wealth management and banking services to corporate customers and individuals. It offers an array of personal and business banking services, with its lending services covering commercial real estate, commercial and industrial, residential real estate, real estate construction and development, small business administration, consumer and other loan products.

Enterprise Financial Services Corp’s (NASDAQ:EFSC) business model, management team, and associate base have been constructed to perform appropriately in any economic environment, with its Q2 2024 results being the product of years of development.

In the quarter, it expanded its margin, grew net interest income, experienced positive operating leverage, and continued to significantly compound tangible book value per share. The company has been working for the last several years to diversify its business model so it does not have to depend on one business, asset class, or market to produce high-quality and predictable earnings. Its Q2 results are the product of this strategy.

Net income reached $45.4 million for the quarter, or $1.19 per diluted share. Net interest income increased by $2.8 million to $140.5 million. Enterprise Financial Services Corp (NASDAQ:EFSC) has managed to hold this number at or around $140 million for the last six quarters despite challenging interest rate conditions. This highlights its strength, positioning it to produce high-quality earnings that continuously improve shareholder value through deep-rooted client relations.