3 reasons investors should rotate into smaller stocks, according to Citi

Small- and mid-sized stocks look well-positioned for gains, Citi says.

After a rally this summer, inflows to smaller stocks have dwindled in recent weeks, but the under-the-radar corner of the market may be poised to outperform in the coming months, Citi analysts said.

The analysts point to a host of factors, from a low bar for earnings beats to factors related to a potential Donald Trump victory, as signs pointing to an upcoming rally for small-caps.

The analysts said that smaller stocks have a lower bar to clear for earnings growth, making it easier for them to impress Wall Street when they report results.

They say small and mid-cap stocks are pricing in 2%-10% growth in earnings-per-share over the next three years, while the S&P 500 is expected to show 15%-22% EPS growth.

“While earnings surprises have been stronger up cap thus far in Q3 reporting, larger or similar percentage beats in certain Small/Mid Cap sectors/names may be rewarded more by markets given a lower bar into results,” the analysts said. “The S&P 500, driven by the Magnificent 7, may need stronger results and upward forward estimate revisions to justify current levels.”

Second, smaller stocks may be hedged from risks related to a second Donald Trump presidency.

Trump has proposed sweeping tariffs of 20% on all imports and tariffs of 60% or more on goods from China. The analysts said small-caps have historically been hedged against tariff-related risks.

They pointed to how small caps initially outperformed on his surprise victory in 2016, and again after he implemented steel tariffs during his first term.

“In both cases, Small/Mid Cap round-tripped relative performance gains when economic data came in softer than expected,” the analysts said.

At the same time, the market doesn’t seem to be expecting much strength from small caps in the case of a Trump win, meaning they have further room to run, the analysts say.

“Conversely, with low implicit growth expectations, Small/Mid Cap to some degree could be a Trump trade with relatively little priced in at current levels,” they said.

Finally, their third point noted that small caps generally are less liquid, though they noted that focusing on smaller names could be a trade-off given the opportunities.

“Impressive Large Cap performance has clearly created some hesitancy to move down cap, and related, down in liquidity. To us, a move down cap in search of alpha opportunities could help manage certain risks, offering investors a trade-off for lesser liquidity relative to Large,” the analysts said.