Small-cap stocks have big problems: How to pick winners

  • By Nicholas Jasinski,
  • Barron's
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Until September, 2018 was on track to be small-caps’ year.

A growing economy and a resilience to a stronger dollar and higher tariffs put the spotlight on smaller, U.S.-focused companies. The Russell 2000 index (.RUT) hit an all-time high on Aug. 31, notching a 14.3% year-to-date return versus the S&P 500’s (.SPX) 9.9% return.

Then things got ugly. As investors fled stocks more broadly, concerns over small-caps grew particularly acute. Mounting cost pressures and concerns over slowing growth led many investors to simply lose faith in small-cap profit margins and earnings expectations, says Lori Calvasina, head of U.S. equity strategy at RBC Capital Markets.

The Russell, which includes 2,000 U.S. companies with a median market value of $964 million, is now off 17.4% from its Aug. 31 record close, and is down 5.6% on the year versus the S&P 500’s 0.9% decline.

Wall Street’s consensus estimate still calls for small-cap earnings to grow by 19.2% in 2019, compared with 2018’s 23.8%.

That’s optimistic, says Eduardo Lecubarri, global head of small and mid-cap equity strategy at JPMorgan. In a best-case scenario, he sees a 15% upside for small-caps next year, with 10% coming from earnings growth and 5% from a rebound to historical average valuation levels.

And an above-average valuation is hard to justify in the 11th year of a bull market, Lecubarri says, because once an inevitable recession arrives and earnings fall, premium valuations become even more stretched.

Dan Hughes, client portfolio manager at Vaughan Nelson Investment Management, says you can stick one of four problems to practically any company in the small-cap space: “They’ve either got a valuation issue, they’ve got slowing revenues, they have margin pressure, or they have excess leverage. And often it’s a combination.”

So what’s a Barron’s reader looking to invest in small-caps in 2019 to do?

Be choosy. Lecubarri suggests seeking a safe haven in “quality value” stocks with high free-cash-flow yield, low net debt to earnings before interest, taxes, depreciation, and amortization, or Ebitda, and below-market volatility. Andrew Boord, co-manager of the FAM Small Cap Fund (FAMFX), likes companies with pricing power that can pass along their increased costs to customers.

“My favorite example is Monro (MNRO) auto repair,” Boord tells Barron’s. “If you go in to get a water pump replaced you probably won’t know that it’s 3% more costly than it was a year ago. And you don’t care, you just need the damn thing fixed so you can go to work tomorrow.”

Boord also prefers companies with only modest cyclicality that can continue to grow over many years under almost every conceivable economic scenario. He cites two small-cap names in the consumer staples space with consistent businesses currently trading at discounted valuations: Twinkie-baker Hostess Brands (TWNK) and Multi-Color (LABL), which provides labels for companies in consumer packaged goods.

Jeff James, portfolio manager for the Driehaus Small Cap Growth fund (DVSMX), is treating the Russell 2000’s selloff this fall as an opportunity. While the index’s average 2019 earnings estimates have been reduced, he still sees plenty of individual names that he expects to grow faster next year or exceed earnings expectations that are now available at more attractive valuation levels. Those companies tend to be differentiated from a product or market positioning standpoint and have superior earnings growth while gaining market share.

One of James’ top picks is gym chain Planet Fitness (PLNT). The business has defensive characteristics that should hold up well even in a slowing economic environment due to its high value proposition for its members at just $10 a month. Earnings are expected to increase over 19% next year, thanks both to continued sales growth in existing locations and new gym openings.

For Randy Gwirtzman, portfolio manager of the Baron Discovery fund (BDFFX), sticking to secular trends that will continue in 2019 is the way to go. One of his preferred themes is the increasing awareness and demand for cybersecurity.

He cites several small-caps in the sector including ForeScout Technologies (FSCT), Qualys (QLYS), and Varonis Systems (VRNS). Each offers software or services that are increasingly non-discretionary for companies growing ever more reliant on data and the internet of things for their businesses, Gwirtzman says.

After the market decline this year, small-caps certainly look cheap relative to large-caps; historically, such dislocations are small-cap buying opportunities. But that doesn’t mean valuations can’t get cheaper in the short term as challenges mount for the index’s negative earners and more cyclical constituents, says RBC’s Calvasina.

Small-caps’ weakening balance sheets is another reason to be cautious, says Lecubarri of JPMorgan. Years of near-zero interest rates have left U.S. small-caps with all-time high average leverage.

One more concern for the Russell 2000 is the index’s increasing proportion of negative earners—a topic Calvasina says frequently comes up with her clients. About a third of Russell 2000 companies don’t turn a profit, compared with less than 10% of the S&P 500. Those are the kinds of companies investors tend to flee late in a cycle when rates are rising and further slack in the economy runs out.

“You probably can’t own small-caps as an index,” says Vaughan Nelson’s Hughes. “Owning the entire market and anticipating returns like you’ve seen the last three to five years, I think you’ll come up short.”

That makes 2019 a year for the stock pickers: “If you just buy the index now, you are going to be buying a lot of low-quality stuff,” Calvasina says. “The active management community is well aware of this issue. I think they know how to navigate around it, and this is the kind of environment where you do want to shift to the active managers.”

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