Small-Cap Surge: 3 Stocks Ready to Ride the Market Rotation

Key Points

• As the stock market excess concentrates in the S&P 500 and large-cap stocks, investors have reasons to believe that small caps could start to outperform.
• Three names stand out with potential double-digit upside in the coming months and are ready to be considered.
• Institutional investors like the setups in these names, and fundamental tailwinds are ready.

When the stock market seems to be on a roll, trending ever so higher without much interruption, there comes a point when the excess returns begin to concentrate in a single area while leaving most other worthy names behind. Today, as the broader S&P 500 hovers near its all-time high prices, a different area of the stock market (and the economy) is beginning to catch up. This run could lead investors to fantastic portfolio risk-to-reward setups; here’s where.

Small-cap stocks, as measured by the performance in the iShares Russell 2000 ETF NYSEARCA: IWM, have fallen behind the S&P 500 by just over 1% during the past month. However bearish this may seem in the short term, one thing should be noted by watchful investors. On February 13, 2025, small caps outperformed the S&P by over 0.6% in a single trading session. This means that, on good days, small caps are beginning to see more momentum than large caps.

The lesson to be taken from history is that when good days favor certain areas in the market over others, investors should pay attention to why that is and whether it is set to keep repeating. Recent trade tariffs have shifted the focus to domestic businesses, a tailwind for small caps, and opportunities in names like Denny’s Co. NASDAQ: DENN, Bath & Body Works Inc. NYSE: BBWI, and even FMC Co. NYSE: FMC for reasons that will become clear in just a bit.

Free Cash Flow Efficiency Makes Denny’s Stand Out

Now that it has become clear, through tariffs and a recent shift in inflation readings, that only businesses with strong financial performance are the ones that matter, here is one name in the retail sector that might be worth a look. Denny’s stock, as unassuming as it may be, has double-digit upside potential due to this factor.

The company’s financials show a gross profit margin of just over 34%, significantly above the rest of the restaurant industry. With ample cash to keep from each sale, a 4.5% net income margin is also impressive, but that’s not why investors should look into this stock.

It’s all about the free cash flow (operating cash flow minus capital expenditures). Denny’s operates on a free cash flow margin of 5%, which is not the most exciting but still enough to make it stand out compared to peers. Here’s the best part: investors can buy this free cash flow for only 10.0x on multiple bases, which is considered cheap.

That might be why Wall Street analysts feel comfortable placing a consensus price target on Denny’s stock of up to $8.10 per share today, which calls for a net upside of as much as 67% from today’s prices. The rotation into small caps could have Denny’s at the front of it.

Bath & Body Works Stock’s Defensive Offer

Most would think that personal care and such products would be part of the consumer discretionary sector, but in reality, Bath & Body Works' products fit the defensive category a lot more. Considering that it probably doesn’t matter whether the economy is booming or busting, consumers will have room in their budgets for these products.

This is why the company’s financials showcase a 44% gross margin rate to get the company into standout territory compared to peers in retail, not to mention a return on invested capital (ROIC) rate of over 30%. ROIC matters because it’s what allows a company to compound value onto itself, the stuff that value investors like Warren Buffett always look for.

Investors shouldn’t be surprised to see analysts at Wells Fargo place an overweight rating on Bath & Body Works stock as of January 2025, which came along an implied upside of 31.5% through their $48 a share price target.

Why Institutions Flew Into FMC Stock

Recent price data, through the producer price index (PPI) report, showed the market that the price of eggs and fertilizers is slightly higher than usual. To fix this, there have been talks of implementing new technology to make the agriculture sector more efficient and capable of fulfilling new capacity demands.

This is where FMC stock comes into play, as a chemical maker and a vital player in the domestic farming industry through its fertilizer products. By trading at only 54% of its 52-week high and being exposed to these tailwinds in the United States, some institutional investors saw enough reason to start gaining some exposure to it.

Such as those from the Vanguard Group, who decided to boost their holdings in FMC stock by as much as 1.2% as of February 2025. This may not seem like much on a percentage basis, but it was enough to bring the group’s position to a high of $743.3 million today, or 12.3% ownership in the company.