What to buy after the Fed stops hiking rates, according to Bank of America

The Federal Reserve’s rate hike cycle may be coming to a pause — and Bank of America thinks some smaller names could outperform.

The central bank hinted in its May post-meeting statement that it may not raise rates beyond the current range of 5% to 5.25%. Bank of America said its economists expect cooling inflation and a mild recession in the coming months following the pause in tightening monetary policy. 

If this is the case and the Fed does end its rate-hiking campaign, investors may want to consider investing in some small-cap stocks that have done well historically.

BofA strategist Jill Carey Hall said that based on historical trends since 1989, quality stocks were the top outperformers within small-cap names over the six and 12 months after the final rate hike in a cycle. Value names also generally beat growth ones, she added. With this in mind, Bank of America screened for Russell 2000 buy-rated stocks that rate highly on those attributes.

These stocks fell within the top two quintiles in returns on invested capital, have a low valuation — based on their free cash flow-to-enterprise value ratio — and high one-month changes in their 200-day moving averages. They also have had the best historical performance in the six months following the last Fed hike in cycles since 1989.

Sporting goods retailer Academy Sports and Outdoors made Bank of America’s list. The stock has a return on invested capital of 20.27%. Shares have gained more than 9% year to date, beating the S&P 500. Analysts are also bullish on the stock, with 14 out of 15 analysts covering the company rating it a buy or strong buy, according to Refinitiv data.

Texas Roadhouse is another consumer discretionary name on the potential outperformers list. Shares have surged almost 25% in 2023 and reached a new 52-week high on Wednesday. To be sure, analysts covering the stock only see 2.1% additional upside from Tuesday’s closing price.

Two of the energy that made the list include ChampionX and PBF Energy. Both companies have seen share prices fall in 2023, with losses of 7.6% and 10.1%, respectively. To be sure, the stocks are still up more than 10% over a 12-month period.

ChampionX’s return on invested capital is almost 19%. Seven out of nine analysts covering the stock rate it a strong buy or buy. The average price target on shares implies more than 32% upside from Monday’s close.

Metals companies Kennametal and Commercial Metals are also well-positioned to outperform in the six months following a pause, according to Bank of America. Commercial Metals has a capital returns rate of 31.7%. Analysts estimate the stock could rally an additional 25.6% in coming months, according to Refinitiv. Shares gained 2.7% Wednesday afternoon. Meanwhile, the steel manufacturer’s stock is down 7.4% year to date.

Kennametal’s stock, meanwhile, is up 7% in 2023. However, analysts are mixed on the stock, with three-fifths of those covering Kennametal giving it a hold rating. The consensus price target implies shares rising just 6% in coming months.

— CNBC’s Michael Bloom contributed reporting.