9 stocks to buy as historically cheap small caps rally during a risky earnings season: Bank of America

• After lagging for nearly three years, small caps are finally roaring back to life.
• But a top small-cap strategist at Bank of America is still cautious due to weak earnings.
• Here are nine top stocks in sectors that should outperform.

Smaller stocks are on the verge of breaking out of their longest drought since the financial crisis, but a leading strategist cautions that the dry spell could continue for some unlucky companies.

Jill Carey Hall, who leads Bank of America's US small- and mid-cap strategy team, has waited nearly three years for the group she covers to retake center stage.

The spotlight finally shone in mid-July, as the small-cap-heavy Russell 2000 has skyrocketed 10.5% in the last two weeks to within striking distance of its all-time high. Another 9% or so would put the index at an all-time high for the first time since November 2021. US small caps hadn't been down that long since the painful stretch from mid-2007 to early 2011.

While smaller stocks languished, large-cap companies dominated, due in part to enthusiasm about their exposure to artificial intelligence. The valuation gap between the groups hit historic levels, as Hall noted that the Russell 2000 traded at a 25% to 30% discount to the S&P 500.

Bank of America

Remarkably, the Russell 2000 remains roughly 28% cheaper than the S&P 500 — even after logging a double-digit gain while the latter was almost flat. The small-cap index is still a steal on a relative basis, even though its forward earnings multiple is just above its long-term average.

Bank of America

This valuation discrepancy is no secret, so Bank of America believes the market rally will broaden beyond the mega-cap leaders as investors shift toward smaller stocks.

"We do expect the rest of the S&P 500 to now see some catch-up, and we're more positive on that part of the S&P 500 than the Magnificent Seven, in terms of where we could see more upside at this point — given a lot of the good expectations have already been baked into the valuations of that top cohort of the market," Hall said in a recent interview.

Small caps are set for a revival, but some won't participate

Most stocks should benefit as the US economic expansion continues and inflation falls, which will allow the Federal Reserve to cut interest rates later this year, Hall said.

But the strategy head said smaller companies look especially promising in this backdrop since they're often reliant on economic growth and are more likely to have short-term, floating-rate debt than their large-cap counterparts. When rates fall, they'll get much-needed relief.

However, Hall hinted that not all smaller companies are in the clear.

Earnings expectations for small caps have tumbled in the last several months, Hall said, noting that analysts are no longer pricing in positive profit growth. There haven't been many surprise beats in the second-quarter earnings season so far, and forward guidance has been lacking.

"It's still early, but trends have been much better for large caps, in terms of the proportion of companies beating on earnings and sales," Hall said. "Guidance has still generally been weaker than average for small caps."

Unless small-cap companies start posting better results, it's fair to wonder whether the market got ahead of itself. Until Hall sees more encouraging signs, she's retaining some skepticism.

"If we can see a beat-and-raise earnings season, if we see better guidance, if we see estimate revisions stop falling or potentially even start to turn up, I think that would give investors a lot more confidence that the profits recovery everyone's been expecting is actually coming to fruition," Hall said. "Versus if we continue to see estimates get revised down even further, that just kind of calls into risk that recovery that everyone's been baking in."

But even if small caps as a whole disappoint during Q2, Hall said companies that exceed expectations by posting positive earnings may be rewarded even more than usual.

9 small-cap stocks poised to ride this rally

Given how wide gaps are in markets — both between valuations of large caps and small caps and the earnings results of the haves and have-nots — Hall recommends actively investing.

"This is an environment where you want to be selective and focusing on attributes and factors," Hall said. "Focusing on stock picking makes sense until we can get a potentially bigger 'all clear.'"

Three economically sensitive sectors look especially attractive as growth holds up and rates fall, Hall said: energy, industrials, and materials. Those groups are cheap relative to defensives and have the least refinancing risk, the strategist noted.

In light of Hall's advice to hand-pick stocks, Business Insider reviewed Bank of America's list of top small- and mid-sized stocks from last month and narrowed it down to companies in those most-preferred sectors.

Below are the nine small- or mid-cap companies in the energy, industrials, or materials sector that Bank of America is bullish on, along with the ticker, market capitalization, sector, industry, price target, upside to that target, and selected commentary from Hall and her team for each. Note that price targets are as of mid-June and may have been updated since.