Small Cap Earnings Could Jump 20%. Plus, a Beer Mystery.

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Small caps have been underperforming for, for over 10 years now. So historically speaking, we're due for, for an outperformance cycle for small caps.

Hello and welcome to the Barron's Streetwise Podcast. I'm Jack Howe, and the voice you just heard is Jill Carey Hall. She's a strategist who covers small caps for B of A Securities. Jill predicts a big move for small caps in 2026. Now, I know we've heard predictions like that before and that they haven't panned out recently, but I find Jill's case compelling. It has a lot to do with earnings growth. We'll talk about that. Listening in is our audio producer Alexis Moore. Hi Alexis. Hey Jack. I received a lot of email. I always receive a lot of email from our lovely listeners. Some of our nuclear literate listeners pointed out I made a bit of a boo-boo, didn't I?

You did.

I strayed. From what I should have said about uranium. I said some scandalous things about uranium.

You said that uranium-235 and 238 have a different number of electrons when in actuality they have the same number of electrons and protons, but a different number of neutrons, which I just learned.

You know what? This changes everything about how I thought the world works. I gotta go back to square one. I'm going back to kindergarten and I'm starting over again.

I don't know if they teach that in kindergarten.

Well, I don't want to miss anything. I don't want to miss any of the building blocks that might be important later on. No, I really do appreciate folks pointing out my mistake. And thanks for listening. We need lots of chemists and engineers on alert to make sure we're getting things right. Now we're going to get to our conversation with Jill from B of A about small caps in just a little bit. I want to say a few words about beer. This is a delicate one because it has everything to do with immigration rates. Americans have sharply different views on those. It's an emotional issue. And what I'm about to say might sound almost frivolous in light of that, but it gets to how Wall Street thinks about bad news and when we reach a point when it's already baked into results. It's something that Wall Street is talking about with a company that reported earnings this past week, and it has to do with Mexican beer, Corona, Modelo, The company that sells those beers is called Constellation Brands, and Constellation was one of the best growers on Wall Street for years. The beer industry had been in a slump. Constellation had bucked that trend. These brands gained share, and the US Hispanic population was growing quickly. These were all tailwinds. If you look at the decade that ran through 2022, investors who held Constellation stock made 22% a year versus 13% for the S&P 500 and just 4% for Molson Coors. They actually lost a bit of money in Anheuser. So that record of outperformance has now changed. In the year up until this past Thursday's earnings report for Constellation, the stock price had fallen by about one-third. And there's a question that Wall Street analysts and company management have kind of been alluding to, maybe dancing around for about a year. Beer is by far Constellation's biggest business, and more than half of its beer customers are Hispanic. And management has talked in the past about what it would call macroeconomic concerns among these customers. I'll talk about some of those concerns in just a moment, but there's a theory on Wall Street that immigration rates have had a lot to do with falling demand for Corona and Modelo. If some of these customers have been avoiding, let's say, big social gatherings where beer is typically enjoyed, Maybe that's hurting. And using Wall Street's sometimes weird logic, that might be a reason to think that the worst of Constellation's stock declines are over. That's what Barclays Capital wrote recently. It wrote, we heard some growing optimism behind Constellation into the close of calendar 2025, with the bull thesis anchored in the idea of lapping the beginning of ICE activity in Constellation's coming fiscal year. That brings the company back to normal seasonality and moderate growth. By the way, Barclays is skeptical about this idea. I'll get to that too. So what does this mean? Lapping stock investors care a lot about growth. If I tell you that a company makes, let's say, $100 million a year in, let's call it revenue, well, who cares? We don't know whether that's better or worse than it was doing before. If I tell you it made $80 million last year and this year it made $100 million, now that's something. That's fast growth. If something happens to that company that, let's say it loses $10 million of its revenue, then we're gonna see percentage declines. In fact, we're gonna see them for 4 quarters. But if that thing that cuts into sales doesn't get worse from there, if the effects have already been fully felt, then we're eventually going to lap whatever caused those declines, and we're gonna have a lower baseline going forward, and that company could return to growth. So if these high-profile ICE raids, Immigration and Customs Enforcement, if they began roughly a year ago, shortly after Inauguration Day, and if they matter a lot for beer sales, that's an open question because there are definitely some other effects too. If they matter and if we're reaching the one-year anniversary and if the effects have already been fully felt, whatever percentage decline may have been caused by immigration fears That percentage decline might go away once the bar is reset lower. Maybe Constellation returns to growth. And that's why Barclays says it's hearing rising optimism about a stock that's been doing poorly over the past year. We did get some new comments and a new piece of evidence from Constellation management this past week. I'll tell you about that. Let me just give you some very brief background on why we're talking about a company from New York's Finger Lakes region. That's selling Mexico's most iconic beers. I've surely talked about this before on this podcast. There was a guy named Marvin Sands, and he was the son of a Queens, New York vintner. And in 1945, he took over a sauerkraut factory that had turned into a bulk winery in Canandaigua, New York. That's about a half-hour drive from Rochester. And what Marvin needed was a hit brand to squeeze higher profits from his grapes. He tried kosher wine called King Solomon. It didn't really take off. But then the company struck gold. Richard's Wild Irish Rose. It's a cheap, sweet, and let's say effective screw cap affair. Lots of repeat customers, and it absolutely minted money for decades. In the 1990s, Marvin's son Richard and his brother led Constellation into premium spirits and wines. They would eventually dump Rosie, as Richard's Wild Irish Rose is sometimes called, along with other cheap bottles. In 2013, Constellation struck gold a second time in beer, of all things. The parent of Budweiser, AB InBev, it bought Grupo Modelo, and as part of an antitrust deal, it had to sell US rights to Corona, Modelo, and the company's other brands. Constellation had limited beer exposure at the time, which made it a safe buyer. These were really unique assets. The Corona brand at that time was this rare combination of iconic, recognized everywhere, but also woefully under-marketed. And that's a fairly straightforward thing for a company to fix. Constellation's innovations include just putting the stuff in cans. The U.S. Hispanic population was growing quickly, which helped. Remember the Bud Light boycott 2 years ago? At that time, and I know we talked about this, Modelo became America's best-selling beer. The stock returns for Constellation investors, as I said, during that period were stupendous. Okay, so what went wrong? Well, one theory is simply that Constellation has tapped its growth opportunity with Modelo. Maybe it now looks like other big brewers. In that quarterly report last Thursday, we learned that depletions, that's an industry term for brewer shipments, Those were down 4% for Modelo and 9% for Corona. They were partially offset by some smaller brands that did well, Pacifico and Victoria, but overall Constellation's beer category fell 2.2%. However, management noted that its beer still has 20% less distribution than that of the industry heavyweights. And that to me doesn't sound like a company that has run out of room for growth. Theory 2 is that the stock was just priced for perfection, and then perfection ended. This one definitely played a role. Shares routinely went for 22, 23 times earnings leading up to 2 years ago. Other big brewers back then traded at price-earnings multiples sometimes in single digits. Now Constellation stock is below 13 times earnings. In recent years, we've seen Constellation stock fall more often than not. On earnings day, but on Thursday it gained 5%. Wall Street called the results good enough considering that the case for shares rests on a future return to normal conditions. There are some other things to look forward to. There's a World Cup of soccer coming this summer. It's co-hosted by the US, Canada, and Mexico. That's gotta help beer sales. Okay, theory 3 is that Hispanic customers are buying less beer because of economic concerns, and theory 4 is that they're doing so because of immigration fears. And these are difficult to disentangle. Back in April of last year, the CEO, Bill Newlands, he cited company research showing that two-thirds of its Hispanic customers were concerned about higher prices on food, gas, and other essentials. And about half of them were concerned about, quote, immigration issues. He also mentioned that concerns about job losses in, quote, industries that have a high Latino employment base. These were leading to declines in, quote, efforts to go to restaurants, to have social gatherings, things that are very much beer occasions. Since then, Constellation has used mostly blanket terms to discuss what's ailing its Hispanic customers. Socioeconomic concerns, for example. But it's just not something that's easy to quantify. It could be a combination of two or more of these things, plus other factors. Now, as I say, the company did tackle this question in a more head-on way this past Thursday. An analyst from TD Cowen asked, I guess what we're all kind of wrestling with is once we lap that initial shock of restrictions on immigration policy, is it possible that it just gets a little bit less bad? So instead of mid-single-digit declines, just theoretically with this cohort, since you're lapping the initial shock, it could be a little bit better than that. To which the CEO answered. We hope you are correct. That would be a lovely outcome. And then he offered this statistical clue. The company tracks results by zip code and compares that with the Hispanic population in those zip codes. And what it finds is that, quote, with zip codes that have greater than 20% Hispanic representation, it still remains very challenging. But it says it, quote, has seen some improvement in zip codes with less than 20% Hispanic representation., and it said it's seeing a lot of volatility state by state, quote, depending on what is going on with immigration policy in particular markets. The company says it's difficult to know, so it's focused on, quote, controlling the controllables. Wall Street is predicting a 16% decline in Constellation's earnings per share for its current fiscal year that runs through February. Next fiscal year is predicting a 7% rebound. But that estimate has been sliding in recent months. Barclay calls this immigration raid thesis for Constellation stock a trading idea, but not really a long-term reason to hold the stock. It writes, quote, we could understand there being limited risk of additional headwinds from reduced social behavior beyond what has already transpired. It goes on, but we think it remains to be seen what lapping does or doesn't mean for the company at large., and that's beer and Constellation. Who wants to hear about small caps, about why to own them in 2026, and about some individual small cap stock picks? That's coming next after this quick break.

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Welcome back. Small cap stocks have stunk for years. That's because their earnings growth has stunk relative to growth of large cap stocks. But did you know that that situation is expected to reverse in 2026? Earnings growth for small caps is expected to exceed that of large caps And historically, that's been excellent for small-cap returns. And also, small caps look pretty cheap right now. That's the thrust of the case made recently by Jill Carey Hall. She's a B of A strategist focusing on, let's call it, SMID caps, small and mid caps. I spoke with Jill recently, and she just published a list of B of A's top SMID-cap stock picks for 2026. Let's listen to part of our conversation. Afterward, I'll share with you some of those picks. I'm speaking with Jill Carey Hall. You're a stock strategist at BofA Securities. I read your reports on small and mid-caps, and you have one that's a look ahead for 2026, and you say this is the year of the big recovery for small caps. When I hear someone say that, I say I wanna believe it, but I'm not quite sure because it's been a while. It's been a long wait. But I'm digging into your report and you've got some points here that are convincing. So I want to go through it with you. Can you tell me about what has happened in the past, why small caps have maybe disappointed for a while, what the connection is with earnings growth and what's different now?

Yeah, and good to be here. And it has been a long time. I mean, usually these cycles for small caps versus large caps tend to run about 6 to 8 years if you're thinking about, you know, longer-term cycles of when they've outperformed or underperformed. But small caps have been underperformed performing for, for over 10 years now. So historically speaking, we're due for, for an outperformance cycle for small caps. And, and that's what valuations would suggest as well. Usually valuation doesn't tend to be that predictive over the coming months or even a few years, but over 10 years, we tend to find that it has high explanatory power on what an index does. But I think to your point, you know, what's different this year relative to the last few years has been We are looking for an earnings recovery for small caps. These stocks were in an earnings recession for the last several years and they were struggling to get out of it. And I think a year ago there was a lot of optimism going into 2025 that these stocks would see a big profits recovery and that the profits recovery would outpace large caps. But that can kept getting kicked down the road. Expectations for that profits recovery kept getting pushed out. And on top of that, you had a lot of uncertainty last year around tariffs, around policy.

So what Why would the experience of small companies be different from large companies when it comes to profit growth? Like, why were they in that earnings recession? We hear about these giant tech companies and it's everybody spending wild amounts of money on artificial intelligence. And why would the experience be different for small companies?

So we did have an overall profits recession for small and large caps, but large caps actually recovered faster out of that earnings recession. Usually small-cap earnings get hit harder and recover faster, but we didn't see the recovery part. We were in a manufacturing recession. So, you know, when you think about the ISM manufacturing indicator, that's been struggling to get back above 50, which marks expansionary territory. Small caps are very sensitive to manufacturing. And, you know, you've had an increasing proportion of stocks in the Russell 2000 that are non-earners, non-profitable stocks. So in an earnings recession, you know, a lot of these stocks struggled even more. And on the large-cap side, you obviously have had very strong earnings growth led by tech and the mega caps. So, You know, it's been a tougher backdrop for small caps, but we're finally at a point where not only are consensus expectations for profits growth to recover this year, but you're finally seeing companies guiding that way. So corporates usually are more conservative in their guidance, but in the recent earnings season, we actually saw company management guiding above consensus, above what analysts are penciling in, even for small caps. So that's a good sign for this expected profits recovery and estimate revisions going forward.

So what's that profit recovery going to look like? What's possible for earnings growth for small caps in 2026, and how does that roughly compare with large caps?

So right now analysts are penciling in close to 20% earnings growth for small caps this year. Wow. And versus, you know, kind of a mid-teens growth rate for mid-caps and a low to mid-teens growth rate for large caps. I think 13% is what's penciled in right now.

Are those numbers that we tend to get? I mean, what do you think? You think 20% is possible?

I mean, typically analysts often start out optimistic and then, you know, numbers get revised down throughout the year. Very recently we've been seeing more positive trends in revisions and guidance for small caps, which is the opposite of what we've seen the past several years where numbers kept, you know, kind of disappointing. I think the other factor that we've been watching and that's been important for small-cap profits and small-cap sentiment overall has been interest rates and the Fed. So going into last year, that was when we were seeing a lot of uncertainty around when the Fed was going to be able to resume cutting rates. Rate cuts were getting pushed out. So combined with the uncertainty around tariffs and policy. That was kind of one big difference from start of last year to now, that after Jackson Hole, when this August we heard Fed Chair Powell get more constructive on the prospects for rate cuts, that's when we got more constructive on small caps.

How do small caps benefit from those cuts versus large caps? Which group benefits more? Right.

Small caps have certainly been a lot more sensitive, especially in recent years, to rates and to Fed expectations because they have a lot more debt. They have a lot more leverage. You know, not as clean balance sheets as these larger stocks. Large companies were able to kind of clean up their balance sheets. They have a lot of long-term fixed-rate debt that they locked in at very low rates versus small caps have more short-term and floating-rate debt. They have more refinancing risk, a lot more debt that's coming due over the coming years. So interest expense is a big focus for these companies. So, you know, as investors become more confident that the Fed is continuing to cut rates, that's a positive for smaller companies.

I saw something where you look at the history of returns for small caps when you have these periods of earnings outperformance, of earnings growth like this? I mean, what tends to happen? Do they tend to do well? Does there tend to be some valuation catch-up? What have we seen in the past when you have this fast earnings growth for small caps?

I mean, we, we looked at periods of where basically similar to what we're expecting for this year, where earnings growth for corporates overall is accelerating and small-cap earnings growth is expected to outpace large-cap earnings growth. And when we looked at periods where we saw that in the past, we saw that small caps tend to perform in those periods. About 75% of the time you saw small caps beat large caps in those periods where earnings growth was picking up and better for small caps.

Got it. It feels like every investor right now is sitting in the same chat room online talking about what the new hot thing is that they're all gonna pile money into. So it will be interesting to see if small caps really do become, you know, go from being so out of favor to becoming to, to being the, the hot new thing. I guess 2026 will tell. If you're someone who is underweight small caps or you believe in this thesis that this is gonna be the year of the small-cap recovery, what's the best way to go about participating? There are some ETFs and indexes you can buy. There are a couple different choices. You know, you've got the S&P 600 versus you mentioned the Russell 2000, or you can go into different pockets of small caps, value versus growth or particular sectors. What do you like in particular? What should investors favor?

Well, I do think that small caps overall will outperform large caps this year. So if you're owning the size segment at an index level, that you will see the small-cap indices overall lead the large-cap indices. But within small caps, I mean, we do think it makes sense to be selective. You know, as I mentioned, there have been challenges to the Russell 2000 index over time where growth expectations have come down. You've seen a higher proportion of nonprofitable stocks in the index.

That's the one where I think of it as kind of more of a Wild West. There's a lot of companies in there that maybe they don't make any money. Whereas the S&P 600, that's another small-cap index, but there's an earnings test to get into that one. So that tends to be more profitable companies. And if you're looking at like a price-to-earnings ratio, that one tends to compare more favorably, does it not, than the, than the Russell 2000, because so many of the Russell 2000 companies don't earn, right? Right.

The S&P 600 is a higher-quality index. So there are fewer non-profitable stocks, fewer stocks overall. The Russell has actually outperformed the S&P small-cap index over the past several years, in part due to the fact that low-quality stocks had outperformed this year. Right. So you did see that dynamic where, you know, in some prior years that they either perform more similarly, or if it was a period where quality outperformed, which it tends to do over the long term, then the S&P Six would tend to lead. But I think within small caps, you know, maybe more important than high versus low quality this year, maybe value. We do think that small cap value will work. Typically, you know, one of the most important factors driving when value stocks work versus growth stocks work is the profit cycle. So if, you know, profits growth is accelerating and growth is becoming more abundant. You don't need to pay up for expensive growth if growth is broadening out and becoming more abundant. And value stocks within small caps have been trading at cheaper relative valuations than growth stocks. Growth stocks within small caps are relatively more expensive. So we do like value and we still think it's a good backdrop to be selective. I mean, you know, at BofA, our analysts cover about 1,000 small and mid-cap US stocks, and there's lots of opportunities out there within the small and mid-cap index. And you know, a lot these small caps have lagged for a long time. So we do think this looks like a good setup for the index as well as for stock pickers.

Thank you, Jill. I promised some top mid-cap picks from B of A for 2026. They published a list this past week. I'm going to name 10 of them. It's not the full list. It's a much longer list. No, I can't email you the full list. There are copyright issues and so forth, but I'll give you 10 if you promise not to hate me for not giving you all of them. Okay. Birkenstock. That's the sandal/hairy big toe company. Duolingo. That's online language learning. Wayfair. That's home goods sales. e.l.f. Beauty. That's makeup. We had their CEO on a while back.

Can you say the tickers, please?

Yeah. Birkenstock is B-I-R-K. Duolingo is D-U-O-L. Wayfair is W. e.l.f. is e.l.f. How about Vita Coco? That is I want to say coconut water. What do you call that stuff?

Yeah, coconut water.

I mean, you don't call it coconut milk.

Exactly.

Yeah. The ticker there is COCO, C-O-C-O. 5 more. Alaska Air, ALK. Knight-Swift Transportation Holdings, KNX. That's trucking. Renaissance Re, that's reinsurance, RNR. Southwest Gas Holdings, SWX. And Guardant Health, which calls itself a, quote, leading precision medicine company focused on transforming patient care and conquering cancer with data. The ticker there is GH. And that's 10, and that I think does it for me. Time for outsies, Alexis.

Let's do outsies.

Thank you all for listening. If you have a question you'd like played and answered on the podcast, you can send it in. It could be in a future episode. Just use the voice memo app on your phone. That's the icon that's 2 down from your brokerage app and 2 across from Mario card, and you can send it to jack.hough@barons.com. Alexis Moore is our producer. You can subscribe to the podcast on Apple Podcasts, Spotify, or wherever you listen to podcasts. If you listen on Apple, please write us a review. See you next week.

Data is everywhere, but is it ready for consumption? Morningstar developed the language of global investment data so you have the right ingredients to help you shine. Morningstar, where data speaks.