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HomeMarketSmall-Cap Stocks Are Some of the Best Buys in the Stock Market

Small-Cap Stocks Are Some of the Best Buys in the Stock Market

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Small-cap stocks are priced for jumbo gains. One money manager predicts that they’ll outshine large-caps by close to four percentage points a year over the next five years. A big investment bank is even more bullish on small-caps for the coming decade.

Thoughts on how best to invest, including eight stock picks, in a moment.

Small-caps are companies with modest market capitalizations—the sum value of shares outstanding. Size cutoffs are arbitrary and rise over time with the market. Recently, the
Russell 2000
index of small companies had a median market cap of $1 billion, and topped out at about $13 billion.

Decades ago, market researchers documented what has come to be known as the small-cap effect—the tendency of small companies to produce higher average returns than large ones over long time periods. Small companies are risky, the thinking went, so the extra return compensates investors for taking the extra risk.

But that’s not how things have looked lately. For one thing, the large-company
Russell 1000
has beaten the small-company Russell 2000 by three points a year over the past decade, returning an average of 13.1%.

For another, small-caps have been experiencing lower average volatility than large-caps during periods of market stress, like the 2013 “taper tantrum,” when investors turned cranky over the Federal Reserve saying that it would reduce bond purchases; the United Kingdom’s Brexit referendum in 2016; and the Covid-19 pandemic. That’s the opposite of what investors expect from risky stocks.

Now, there’s a lively debate over whether the small-cap effect is dead, just hibernating, or if it truly existed to begin with. We can leave that one to the academics. Our interest here is simply whether small-caps are unusually cheap now. They are, although it might not appear so at a glance, depending on where you look.

The Russell 2000 is flirting with 20 times earnings, a smidgen above its long-term average and no one’s idea of deep value territory. But weed out the index’s unprofitable companies and statistical outliers, and the price/earnings ratio drops to about 12, versus a long-term average of 15.

This adjustment to the numbers is important now, for two reasons. One is that 33% of Russell 2000 members today have negative earnings, up from 20% a decade ago, and a record high. One industry is more responsible for that than others. “Biotech has become much lower quality over time,” says Jill Carey Hall, head of U.S. small- and mid-cap strategy at BofA Securities. “You have a lot more earlier stage biotech companies that have come to market. That’s an area of small-caps that we’re more cautious on.”

There’s a bigger reason to exclude unprofitable companies when sizing up the Russell 2000: The adjusted P/E has been a better predictor of future returns than the unadjusted one, based on a BofA analysis of data going back to 1985. Right now, the adjusted P/E leads BofA to predict 12% yearly returns for small-caps over the coming decade. That’s five points more than it sees for large-caps.

Company / Ticker Recent Price YTD Change Market Value (bil) 12-Mo. Forward P/E Dividend Yield
Boot Barn Holdings / BOOT $66.83 -46% $2.0 11.3 None
Ceridian HCM Holding /CDAY 68.85 -34 10.5 75.5 None
HubSpot / HUBS 299.94 -55 14.7 109.9 None
Magnolia Oil & Gas / MGY 26.47 40 5.6 6.7 2.0%
Saia / SAIA 233.69 -31 6.4 18.8 None
SiteOne Landscape Supply / SITE 127.31 -47 5.7 26.2 None
Stelco Holdings / STLC.Canada C$44.76 9 1.8 8.9 3.8
Tapestry / TPR $38.30 -5 9.1 9.7 3.1

ETF / Ticker Net Asset Value YTD Total Return Total Assets (bil)
SPDR S&P 600 Small Cap / SLY $88.49 -10.1% $1.7
Schwab Fundamental U.S. Small Company Index / FNDA 50.07 -9.2 6.1
Fund / Ticker
Columbia Small Cap Value II / NSVAX $17.40 -7.7% $1.4
Wasatch Core Growth / WGROX 70.02 -25.6 2.9

Sources: FactSet; Morningstar

Hall calculates that small-caps are 30% cheaper than large-caps now, the biggest discount since the dot-com stock bubble more than two decades ago. One potential negative: The economy could fall into recession in the year ahead, and during recessions, earnings for small-caps tend to fall more than those for large-caps. But right now, Hall says, small-caps are already pricing in a recession on the order of the one during the global financial crisis of 2008-09.

Small-caps outperformed during recessions in the 1970s and early 1980s, when the Federal Reserve was fighting high inflation, as it is now. The group has higher proportional exposure than large-caps to inflation beneficiaries, like energy. It’s also more domestic and more tied to capital spending, which is a plus if U.S.-based manufacturers continue moving factories home. But small companies generally have less financial flexibility than large ones, which is a negative if borrowing rates stay elevated.

One way for investors to add small- cap exposure is with a low-fee index fund like the
iShares Russell 2000
exchange-traded fund (ticker: IWM). Then again, switching indexes might be an upgrade. The
S&P SmallCap 600
index has outperformed the Russell 2000 index by more than a percentage point a year over the past five, 10, and 20 years, and has generally been less volatile. The biggest reason: S&P uses a profitability screen to admit index members.
SPDR S&P 600 Small Cap
ETF (SLY) is one fund option there.

If a profitability screen helps, how about a value tilt? The aforementioned indexes weight small-caps by market cap. Asset manager Research Affiliates has an index that weights them by fundamental measures of value like sales, cash flow, and dividends. Investors can buy in through
Schwab Fundamental U.S. Small Company Index
ETF (FNDA). It’s more expensive than the other funds, but still cheap, with yearly expenses of 0.25%. Since inception in 2013, the fund has returned 7.4% a year, beating the Russell 2000 by nearly a point through Sept. 30.

Que Nguyen, chief investment officer of equity strategies at Research Affiliates, points to a recent, long-awaited bounce for value stocks relative to growth stocks as a harbinger. “Everybody is looking around and saying, ‘What’s next?’ ” she says. “In our opinion, the next shoe to drop is really small-cap versus large-cap for people who invest in the U.S.”

Nguyen’s analysis of small-cap valuations leads her to a conclusion similar to that of BofA. Small-caps are priced to beat large-caps by 3.7% a year over the next five years, she reckons. And that’s if valuations merely return to normal. If they overshoot, as they have during past mean-reversion cycles, small-caps could do better.

Nguyen’s preferred way to invest is, as you might imagine, her firm’s fundamental-weighted approach, but not just for its value bias. The methodology uses some quality screens, like adjusting sales for the leverage that companies use to achieve them. That’s particularly important for small-caps, says Nguyen. When weak large-caps come under stress, they can become mid-caps by the time management turns things around, but when weak small-caps come under stress, “a lot of times you hit that wall, and you just never come back,” she says.

For individual stock picks, here are four from Wall Street’s sell side, or firms that issue and trade stocks, and four from its buy side, or money managers who buy stocks.

J.P. Morgan
says to stick with value-priced small-caps now rather than pay premium prices for the fastest growers. It began tracking a model portfolio of small- and mid-cap stocks on July 15, and it’s off to a fast start, with 13 points of “alpha,” or outperformance, on the Russell 2000.

The list includes retailer
Boot Barn
Holding (BOOT), which has low fixed costs and a leading position in Western wear and work boots.
Magnolia Oil & Gas
(MGY) is a cash generative driller with no net debt. Steel maker
Stelco
(STLC.Canada) also has more cash than debt and has bought back nearly a third of its shares this year. And
Tapestry
(TPR), whose handbag brands include Coach and Kate Spade, is courting younger shoppers with more digital marketing, and income investors with a 3.1% dividend.

Josh Spencer manages the
T. Rowe Price New Horizons
fund (PRNHX) with a growth tilt, sometimes paying elevated multiples for shares of companies that are gathering revenue and cash flows quickly. That approach has fallen out of favor over the past year, putting the fund in the bottom 10% of its group for returns, but the fund has been remarkably successful over the past 15 years, ranking in the top 1%, according to Morningstar. (That’s part of a broader trend at T. Rowe.)

The fund is closed to new investors for now. Among Spencer’s favorite stocks is
HubSpot
(HUBS), which competes with
Salesforce
(CRM) for sales software, and has nearly twice its revenue growth rate. Likewise,
Ceridian HCM Holding
(CDAY) competes with better-known
Workday (WDAY)
on workforce management software, and is building free cash flow quickly from a low base.
SiteOne Landscape Supply
(SITE) sells trees, paving stones, outdoor lighting, and more through more than 600 stores, and trades at 17 times next year’s estimated free cash flow. And trucker
Saia
(SAIA) used a recent freight boom to upgrade its fleet and technology, driving profit margins higher.

For actively managed funds that are open to new money,
Columbia Small Cap Value II
(NSVAX) and
Wasatch Core Growth
(WGROX) get high marks from Morningstar. Each costs a little more than 1% a year and has beaten its category by about a point a year over the past decade.

Write to Jack Hough at jack.hough@barrons.com

Credit: marketwatch.com

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