Federated Hermes said small companies can “harness the power of low expectations.”

The “Magnificent 7” (Magnificent 7), which is dominated by big tech companies, drove the market's rise last year and this year, but with recent lackluster performance, their dominance seems to be coming to an end.

The question traders have been thinking about is whether these gains can inject new vitality into other industries and keep the overall index healthy, or whether the market must decline as a whole before finding new growth drivers.

However, Mark Shellock, manager of small and medium cap funds in the London division of Federated Hermes, pointed out that the bigger problem is that most large cap stocks currently face extremely high expectations of future earnings.

Instead, it presented an opportunity. Shellock said that small and medium capitalization stocks or smaller stocks in the S&P 500 index can “harness the power of low expectations,” so these stocks are likely to bring the best returns.

While his remarks may be of interest, the small and medium cap (SMID) fund he manages has had an annualized net return of 15% since its inception in 2009. However, over the past two years, this is still far short of the earnings of the S&P 500 index of large-cap stocks. The latter has benefited from the strong performance of the “Big Seven”, which has increased by more than 20% per year.

However, Shellock believes there are three reasons why SMID stocks will outperform large-cap stocks in the next few years. First, large-cap stocks are overvalued, while small-cap companies are likely to be undervalued because they have had a difficult time in the past few years. Second, the Federal Reserve raised interest rates to a ten-year high, and industries like real estate have actually experienced a “recession.”

Also, if you are optimistic about the US economy, small-cap stocks are a better choice. Compared to large-cap companies, small-cap companies are more dependent on the domestic economy, while larger companies usually rely heavily on overseas sales. Finally, attractive valuations could trigger a wave of mergers and acquisitions in the next few years.

Election risks

The outlook for the future does not depend on the November election results, because whoever wins could split the government. And financial markets generally view Washington's impasse as a sign of stability.

Shellock pointed out, “The US economy is a giant that is always moving forward, and the winner of the election is probably the economy itself.”

Shellock looks for companies that have good cash flow and can withstand competitive barriers, and tends to hold them for about five years. He adopted a “turtle over rabbit” strategy, providing investors with a “sustainable way to invest in the US economy where people can sleep with peace of mind.”

Here are a few stocks he sees promising prospects:

Not all semiconductor companies are alike$NVIDIA (NVDA.US)$und$Intel (INTC.US)$That huge.$Power Integrations (POWI.US)$It is a small enterprise focusing on high-voltage power conversion units, used in urban lighting and electric vehicles. The stock has not performed well in the past few years, falling from a high of over $100 in 2021 to around $63 today. But as the company works to improve energy efficiency, Power Integrations is expected to recover. The company's market capitalization is around 3.5 billion US dollars. The stock price has fallen 25% in the past 12 months, and the current price-earnings ratio is 38 times. Five of FactSet's seven analysts gave it a buy rating, while two others maintained a holding rating.

There are also trends worth watching, such as moving to the more rapidly growing southern states and companies trying to move more of their supply chains back home.$Martin Marietta Materials (MLM.US)$A company benefiting from these two major trends, it operates a rock mine that produces road building materials. The company is headquartered in Raleigh, North Carolina, and is one of 70 companies included in both the S&P 500 and Russell 2500 indices. The company employs 9,400 employees, and its stock price has risen 23% in the past 12 months, and the price-earnings ratio is 31 times. FactSet's average analysts' target price is $625, which has room for an 18% increase from the recent stock price of $530.

Real estate and home

Investors in the real estate and home improvement sector are going through tough times. People invested heavily in their homes during the COVID-19 pandemic, causing the industry to absorb excess demand ever since. Things now seem to be gradually returning to normal.$Trex Co. (TREX.US)$It is a company that produces decking materials and is expected to benefit when people return to home improvements.$Fortune Brands Innovations (FBIN.US)$It's another company that makes home and security products from Master Lock padlocks to Moen faucets.

These are just a few investment ideas. If the market is about to lose its concentration on larger companies, or if you're looking for small-cap stocks whose growth potential has not been factored into the share price, then small-cap companies are ideal.

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