Yields have climbed to levels not seen in about 20 years, across the 30-year and the 10-year. That makes small caps harder to own. These stocks carry more risk, so they must pay investors more - the equity risk premium.
Why higher rates hit small caps harder
About 30% of small caps hold variable rate loans, so when rates rise, their interest costs rise too. For large caps, only about 6% carry that kind of debt. Higher-for-longer rates are a large headwind for small caps. In this setting, the stocks worth holding have little debt, do not see debt or interest costs rising while margins fall, generate strong free cash flow to pay down any variable debt, and earn recurring revenue. Such companies can still do well. They likely will not beat the broad indexes, but with roughly 2,000 small caps to choose from, there are always a few winners.
Match Group (MTCH)
Match Group (MTCH), owner of an online dating app, fits the profile. Love is a steady, long-run demand story - people always look for it - and its subscription model works like a cash cow. The stock is up about 6% since the rate increase and has beaten the S&P 500 (SPX) year-to-date. It looks undervalued, with roughly another 9% of upside. The path clears once inflation gets more defined and once it is known whether a second rate hike lands this year or in 2027. Match carries low debt.
A caution on timing: markets are entering a risk-off stretch heading into the midterms. There are 40 days before the midterm elections, and volatility usually eases about 10 days before an election, leaving roughly 30 days of turbulence. Stocks with strong free cash flow and recurring subscription revenue get hit hardest in these stretches, then rebound best when conditions calm. That makes the rough patch a buying window.
GitLab (GTLB)
GitLab (GTLB) was caught in the broad selloff of SaaS software names. It is a software company that works closely with Microsoft (MSFT) and supplies the sandboxes where developers test AI bots and tools. Its revenue is software-based with little debt. Recent acquisitions target higher growth, and revenue could rise about 20% this year. Valuation looks low against that earnings growth, making it a fairly safe entry. The next month or two may be rough, but the strong fundamentals make weakness an opportunity.
Dropbox (DBX) skipped, Synopsys (SNPS) instead
Dropbox (DBX) was set to be the third small-cap pick but got downgraded that morning by Citigroup (C), from neutral to a lower rating. Big banks rarely go below neutral, so that downgrade carries weight; the name was set aside for now. In its place: Synopsys (SNPS), a large cap that sells the design software used to build semiconductor chips. Same logic - good value, little debt. Synopsys paid down about $3.5 billion of debt in the first half of the year.
Meta (META) and Muse
Meta (META) had a strong run this week and drew several upgrades, though it pulled back a bit - a normal move after such a run. Meta is one of the companies proving that AI is a scalable business, and it has executed better than some peers.
Things change fast in AI. A year ago, Claude was not part of everyday speech; now people say "Claude says this" or "I looked it up on Claude" almost daily. Meta's Muse could become the next name that reaches that level, so it should not be underestimated. Meta also earns credit for pivoting when a bet fails rather than forcing it - it moved on from the metaverse and the glasses when those did not work. Meta has real potential here.
On personal AI use: any tool is worth trying until the best one shows up. Claude is the current top pick, though that can change, and a switch toward ChatGPT may come soon.
