By Jacob Sonenshine

Smaller stocks have gotten hit particularly hard as markets slide lower. Now, they are trading at levels that have always provided a buying opportunity.

The S&P Small Cap 600, whose components which have an average market capitalization of $3 billion, is down 11% from its record closing high, hit late last year. The S&P 500 has fallen 3% from its record, reached in February.

A combination of related factors has sent the entire market lower. President Donald Trump's 25% tariffs on Mexico and Canada, plus an additional 10% levy on China, are scheduled to go into effect on Tuesday. That could hurt stocks in three ways.

First, the tariffs would increase the cost of importing hundreds of billions of dollars worth of goods, hurting profit margins at companies that can't lift prices enough to offset that expense. Higher prices will add to inflation, meaning the Federal Reserve could roll out an interest- rate increase, rather than lowering borrowing costs, further weighing on the economy. Consumer demand, already at risk as the Trump administration slashes federal jobs, would take a hit, too.

These dynamics tend to hit small-cap stocks the most. Even though it is the larger companies whose supply chains extend throughout the globe, making them more exposed to tariffs, smaller companies' earnings tend to take a worse hit when consumer and business demand drops. They often can't find as many cost-cutting opportunities as larger companies, so lower sales mean a larger hit to profit margins.

Plus, right now, smaller firms have more floating-rate debt. If rates rise, the interest that these companies pay on their borrowings will increase, cutting into their profits.

The resulting pullback has brought small-cap stocks back to attractive levels. Since April, every time the S&P 600 has fallen to roughly 1300, not far from the current level of near 1360, buyers have come into prop it up. Over that time, the average return for the three months following a close below 1360 has been a gain of 7.9%. according to Dow Jones Market Data.

This time should be no different. For starters, while it is difficult to know how much risk to earnings is priced into the stocks, we know that a lot of it is. Markets have been aware of the risk of tariffs since Trump was elected.

Plus, the immediate consequences of tariffs -- higher costs for goods -- won't be a central theme in smaller companies' earnings reports throughout this year. Many just don't have suppliers and operations around the globe, while Apple, for example, buys huge amounts of components from countries in Asia.

Companies in areas that don't rely on imports, such as finance, healthcare services, software, consulting, and energy production, account for just over one-third of the S&P 600's market capitalization, compared with just under a third for the S&P 500, according to FactSet. That means slightly more of the S&P 600's market value will be relatively unaffected by higher costs from tariffs.

The broader economic impact -- consumers may become more budget-conscious -- will take more than a few quarters to emerge. The effects of potentially higher rates historically have taken months or years to unfold.

This sets the stage for second-quarter earnings releases this spring to send small-cap stocks higher. Analysts expect aggregate S&P 600 sales to rise this year and next, lifting profit margins and boosting earnings even faster than sales. Profits are expected to increase faster than for the S&P 500 as growth in Big Tech profits slows after the first couple of years of surging demand for artificial intelligence and related infrastructure.

As long as small-cap earnings this quarter meet expectations, and companies' forecasts outlines a path for continued growth, the stocks may have nowhere to go but upward.

The S&P 600 now trades at 15.5 times the earnings expected for the next 12 months, 6.1 points below the S&P 500's 21.6 times. That is a wider discount than late last year, when the small-cap index hit its all-time high and traded at 17 times, for a five-point discount.

Assuming that price/earnings ratios don't go down much, higher expected earnings would drive the shares upward. Expect small-cap "outperformance [versus large-caps] later in the year if our economic and market outlook plays out as expected," wrote Chris Senyek, chief investment strategist at Wolfe Research, in a research note Monday.

It makes sense for investors to scour the S&P 600 for stocks in industries that aren't tariff-sensitive. Some examples, all of whose earnings are expected to increase over the coming two years, include the following:

   -- Moelis, the investment bank with a market capitalization of $5.3 billion. 
 
 
   -- WisdomTree, the $1.3 billion exchange-traded asset manager. 
 
   -- Bank of Hawaii, a $2.9 billion lender that focuses on borrowers in Hawaii 
      and other Pacific islands. 
 
   -- Banc of California, a $2.5 billion lender that has been acquiring new 
      customers in its state and increasing its total revenue, partly by 
      completing its acquisition of Pacific Western Bank. 
 
   -- National HealthCare Corp, a $1.5 billion provider of nursing, 
      assisted-living, and other home-care services. 
 
   -- U.S. Physical Therapy, a $1.2 billion provider of regular PT and services 
      for preventing and evaluating workplace injuries. 
 
   -- Avista Corp, the $3.2 billion utility provider for areas in Washington, 
      Idaho, and Oregon. 

Write to Jacob Sonenshine at jacob.sonenshine@barrons.com

This content was created by Barron's, which is operated by Dow Jones & Co. Barron's is published independently from Dow Jones Newswires and The Wall Street Journal.

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March 03, 2025 15:43 ET (20:43 GMT)

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