We recently compiled a list of the Top Investors’ Stock Portfolio: 7 Small-Cap Stocks to Invest In. In this article, we are going to take a look at where Kennametal Inc. (NYSE:KMT) stands against the other small-cap stocks.

The market experts opine that strong and stable earnings growth, a favourable valuation environment and the expectation of lower interest rates provide a supportive environment for global small-cap equities. American Century Investments believes that after the outperformance by large-cap stocks, the investors saw a notable rotation toward small-caps in the month of July. That being said, after the early August volatility, investors still wonder whether or not the small-cap stocks are well-placed to sustain through the rest of the year and in 2025.

Tailwinds for Small-Cap Stocks

The US small-cap stocks continue to show signs of renewed momentum, hinting at a shift in performance leadership. Janus Henderson Investors believes that, from mid-July to August end, the Russell 2000 Index outperformed the large-cap indices and the “Magnificent Seven” stocks. The global small-cap stocks have experienced the impact of increased inflation, higher interest rates, and a slowdown in economic growth over the previous 3 years. The sharp increase in rates beginning in 2022 supported in driving a rotation out of small-caps and into large-caps. Therefore, small-cap growth stocks were the ones that particularly saw the brunt.

Despite economic uncertainty, American Century Investments believes that inflation seems to be moving in the right direction, and central banks have started to cut rates. The US Fed’s approach remains more cautious than the expectations. However, with rates expected to decline further, investors are expected to benefit from an environment of moderate economic growth and lower inflation. The investment firm believes that this environment will be conducive to risk-taking and a tailwind for small-caps.

Such a pivot is expected to enable investors to shift focus from central bank policy to corporate profits. This will help create a more favorable environment for active security selection. Over the long term, the investors are expected to be inclined to the companies having improved earnings growth. Also, Janus Henderson Investors believes that small caps have delivered strong performance historically when their market cap as a % of the total market declines below 5%. This threshold was recently crossed.

Valuation Gap Provides Further Opportunity

The extended period of large-cap dominance resulted in the significant widening of the valuation gap between small-cap and large-cap stocks, as per Janus Henderson Investors. The relative valuation of small caps compared to large caps sat at the 16^th percentile (at August end). The investment firm went on to say that ever since the Russell 2000 Index was created in 1978, small caps have been this inexpensive only once.

The current valuations do impact the future returns, and current disparity provides a strong entry point. Lower inflation might disproportionally boost small caps’ earnings expansion because of their typical lower pricing power and increased labor intensity in comparison to larger counterparts.

Additionally, Janus Henderson Investors mentioned that small-cap stocks have historically outperformed large caps by ~10% during the first 12 months after an initial Fed rate cut. The firm believes that the potential return to a normalized cost of capital might fuel small-cap earnings. Therefore, when financial conditions ease, smaller companies get easy access to funding for growth.

Our Methodology

In order to list 7 Small-cap Stocks to Invest In, we used a Finviz screener to filter out the stocks from the small-cap space. Therefore, we chose companies having a market cap of less than $2 billion. Finally, the stocks have been arranged in ascending order of their hedge fund sentiments, as of Q2 2024.

Why are we interested in the stocks that hedge funds pile into? 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).

Kennametal Inc. (NYSE:KMT)

Market Cap as of 9 October: $1.95 billion

Number of Hedge Fund Holders: 23

Kennametal Inc. (NYSE:KMT) is engaged in manufacturing, purchasing, and distributing tools, tooling systems, and solutions to the metalworking, mining, oil, and energy industries.

Kennametal Inc. (NYSE:KMT) recently showcased its efforts in investment and automation, which form part of its strategy to improve efficiency and profitability amidst industry challenges. Additionally, the company continues to explore potential changes in its selling approach, which should help it enhance market penetration and customer retention.

Market experts opine that Kennametal Inc. (NYSE:KMT)’s strong emphasis on innovation and automation should translate into improved operational efficiency, reduced costs, and enhanced product quality. By making investments in cutting-edge technologies, Kennametal Inc. (NYSE:KMT) plans to differentiate itself from competitors and tap a larger market share. The focus on automation should help mitigate the impact of labor shortages and wage pressures.

Moreover, innovative products and processes should help in opening up new market opportunities or applications for Kennametal Inc. (NYSE:KMT)’s expertise in materials science and tooling. As per Wall Street, these initiatives are expected to position Kennametal Inc. (NYSE:KMT) as a leader in Industry 4.0 technologies in its sector and can potentially attract new customers and create additional revenue streams.

For FY 2025, the company expects sales of between $2.0 billion – $2.1 billion, with pricing actions likely to cover raw material costs, wages, and general inflation. It expects its adjusted EPS to be in the range of $1.30 – $1.70. Heartland Advisors, an investment management company, released its second-quarter 2024 investor letter. Here is what the fund said:

“These are companies like Kennametal Inc. (NYSE:KMT), the manufacturer of industrial cutting tools and components that we mentioned in our Q1 commentary. The company is emerging from trough demand and has seen EBITDA contract on a year-over-year basis in 5 of the last 7 quarters. But the company has been undergoing extensive self-help during the past 5 years, taking out $200 million in structural costs, cutting its headcount by 20%, and closing 6 plants as part of an extensive restructuring. The heavy lifting/investment phase seems to now be in the rearview mirror. While demand has not yet inflected higher, sales are stabilizing. If Kennametal sees even a slight pickup in demand in its end markets, that could provide an immediate and robust boost to its operating margins. Furthering our confidence, KMT’s newly appointed CEO purchased shares in the quarter and the company is active on its buyback program.”

Overall KMT ranks 4th on our list of the small-cap stocks to invest in. While we acknowledge the potential of KMT as an investment, our conviction lies in the belief that some deeply undervalued AI stocks hold greater promise for delivering higher returns, and doing so within a shorter timeframe. If you are looking for a deeply undervalued AI stock that is more promising than KMT but that trades at less than 5 times its earnings, check out our report about the cheapest AI stock.

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Disclosure: None. This article is originally published at Insider Monkey.