These 5 small stocks could benefit from an economic rebound

  • By Daren Fonda,
  • Barron's
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Acme United’s (ACU) stock is on a roll, and it has nothing to do with Wile E. Coyote or the coronavirus pandemic. Acme makes first-aid kits, scissors, fishing gear, and knives, and sales have been rising for years. “We’re growing faster than we have historically,” says CEO Walter Johnsen, adding that the biggest impact of the pandemic was to shift sales from bricks-and-mortar retail to online.

Yet Acme is also doing well for another reason: It’s a small-cap value stock—a category that has started to lift off. Signs of a market rotation from growth to value have been popping up lately. And small-cap value is in the thick of it: The Russell 2000 Value Index has gained 14% since Oct. 1, versus 2.4% for the Russell 1000 Growth Index (.RLG). Several factors may be lining up for value, including a turnaround in the economy, demand for higher-risk cyclical stocks, and rising interest rates as economic growth and inflation heat up—all catalysts that have historically created favorable conditions for small-caps to outperform.

“Assuming the economy improves, these names should do well,” says Bill Hench, manager of Royce Opportunity (RYPNX), a small-cap value fund. The category has underperformed for years and it’s trading at one of the deepest discounts to growth in history. With valuations so depressed, the stocks have a cushion to soften the blow if they fail to outperform. “If you’re wrong and they don’t work, it’s like jumping out of a first floor window, rather than the 10th floor,” Hench says.

Small-cap value has had some impressive runs historically, and the idea that small-caps have an embedded “premium”—in short, they tend to outperform large-caps and the broader market over long periods—has been supported by many studies. Based on market returns from 1926 to 2014, the smallest stocks earned 4.3 percentage points more than the overall market, on average, after adjusting for risk, according to New York University professor Aswath Damodaran. Studies also find premiums in value stocks, large and small, compared to more expensive growth stocks.

Those premiums have disappeared for decades, only to reappear again. Value is in a historic funk. Large-cap growth has beaten small-cap value over the past 10- and 15-year periods. Value overall has struggled to catch growth since 2009. And the past four years have been brutal: The most expensive stocks in the market have gained an average of 54% since early 2017 while the cheapest stocks have lost 22%—one of the longest and widest performance gaps in 40 years, says David Corris, head of U.S. Disciplined Equity at BMO Capital Asset Management.

Why bother with small-cap value stocks now? One compelling argument is record-low valuations. Small-cap value is trading at a 60% discount to its average valuation in the postwar era, according to Leuthold Group, and it has been this inexpensive only one other time.

We may also be seeing the start of a market rotation. October was the best month for small-cap value, relative to growth, since November 2016. Four years ago marked the start of Donald Trump’s presidency and an epic run for growth. But a new administration is now coming to Washington. And large-cap growth indexes, dominated by Big Tech, may be due for a pause. Large-cap tech has come under pressure due to concerns about overvaluation, increasing regulation, and investor crowding in the sector.

Indeed, so much capital has flowed into Big Tech that those few companies now dwarf the entire small-cap universe. The Russell 2000 Value Index (.RUJ) has a market value of $1.5 trillion, according to Bloomberg, making it roughly the size of (AMZN). “If dollars start flowing out of Amazon or other stocks like it, and into small value, it’ll have a big impact on returns,” says Eric Kuby, co-manager of the North Star Micro Cap fund (NSMVX).

Small-caps tend to outperform in the early stages of an economic recovery. And market collapses, similar to the one earlier this year, typically usher in “regime changes,” says Phil Segner, an analyst with Leuthold. Investors favoring one group of stocks pivot to another as the economic climate and market sentiment shifts.

Other catalysts for small-cap value would be a pickup in rates and inflation, which create steeper hurdles for growth stocks to outperform. Interest rates on the 10-year Treasury have risen lately, partly on expectations for a larger fiscal stimulus package under a Joe Biden presidency. The higher rates could indicate higher inflation expectations and rising bond yields—though the Federal Reserve isn’t likely to increase short-term rates. Antitrust actions against Big Tech and higher tax rates for multinational companies could also be coming, but small-caps tend to be domestically oriented and don’t face as much regulatory pressure.

Investors could tap into small-cap value with an exchange-traded fund that tracks an index. But small-cap value ETFs have a few shortcomings. They are packed with unprofitable retail, energy, and financial stocks. And small-caps aren’t nearly as widely covered by Wall Street firms as large-caps. That can create more opportunities for mispriced companies and the potential for their stocks to outperform. The following five companies operate in very different industries, but all are profitable, growing, and largely overlooked.

SP Plus

Parking lots might seem like a bad bet, now that so many Americans are working from home and traveling less. Shares of SP Plus (SP), a parking and airport transportation-services company, are down 38% this year, as the company racked up operating losses due to the pandemic.

Yet SP has cut costs sharply and generated positive free cash flow in the second and third quarters, the height of the lockdowns. The company gained service contracts from rival operators that couldn’t survive the pandemic’s early days, and SP deploys touchless payment systems that many smaller operators haven’t installed, giving it a competitive edge. Corporate customers are asking the firm to develop parking plans for employees as they return to work, says Kuby, who owns the stock. “There will be more people driving to work than taking public transportation, and increased demand for parking services,” he says.

Only four analysts cover SP, according to FactSet, but all rate it a Buy with an average target of $33, implying a gain of 27% from a recent price around $26. Analysts expect the company to post $1.28 a share in earnings next year, but a sharper recovery is expected in 2022, nearly doubling earnings to $2.14 a share. At a price of $31, the stock would trade at a price/earnings ratio of 14.5, still well below market averages. “They have tremendous upside tied to a rebound,” says Kuby.

WinTrust Financial

Small banks are in a bind these days: Low interest rates and a flat yield curve are pressuring profits on loans, and high-tech financial-services firms are racking up deposits and customers with services like stock-trading apps and wealth management. The Covid-induced slowdown may also be pressuring credit and asset values.

But Wintrust Financial (WTFC), a regional bank with 180 branches, mainly in the Chicago region, seems to be working through the tough times. Loans issued by the bank have risen by $6.4 billion over the past five quarters, reaching $32 billion, and deposits have increased by $7 billion to $35 billion.

“It’s a well-diversified, conservative, and diversified bank,” says BMO’s Corris, adding that the bank has a higher-quality loan portfolio and stronger reserves than many rivals.

Wintrust is expected to earn $4.32 a share this year and $4.08 a share next year, reflecting expectations for rates to stay depressed. But if inflation picks up as the economy recovers, we could see a steeper yield curve, lifting bank profits in 2022, when Wintrust is expected to earn $4.67 a share. “The yield curve has been steepening since the election,” says Corris, “and assuming Covid fears pass or a stimulus plan is passed, their credit quality will improve.”

The stock isn’t pricing in much growth; it trades at tangible book value, about 60% of its five-year average. It’s one of the largest independent bank s in the Chicago area, and it could be an attractive acquisition for a larger bank that wants a presence in the region.

Acme United

Acme United (ACU), for its part, has survived far worse than the pandemic. The company traces its roots to 1867, making it through the Great Depression and two world wars, and it has expanded for decades through acquisitions and organic growth.

Acme didn’t lay off a single worker through the pandemic as sales increased, shifting from retail outlets to online channels. The company picked up market share as it gained shelf space at chains such as Walmart and Home Depot. Sales of scissors shifted from offices to home use and crafts markets. And demand for first-aid and safety kits—half of total sales—is staying strong. Acme replenishes supplies automatically for its industrial customers, using bar-code technology and remote ordering, saving companies 30% on ad-hoc deliveries, says CEO Johnsen. And industrial sales are fueling retail. “Some large home-improvement chains chose our products because they came from the industrial world and saw we had high-quality components and good pricing,” he says.

Acme is expanding in Canada, recently acquiring a first-aid-kit supplier in Quebec. And it’s growing in Europe through a German subsidiary. Some of its goods that are made in China have been hit with tariffs, and that’s likely to continue under a Biden administration, says Johnsen. With China’s currency strengthening against the dollar, he expects to raise prices to help offset the tariffs next year.

Acme’s growth might not be exciting, but it doesn’t come at a premium. Shares trade at 11.7 times estimated 2021 earnings of $2.28 a share, with profits expected to rise 13% from 2020. “I see plenty of challenges,” Johnsen says, “but not only are we positioned to do well, I’m confident that if we see opportunities, we’ll execute.”

Kuby likes the stock for Acme’s steady growth profile. “This is not the Road Runner company that everyone thinks of,” he says. “They grow every year and they’ve done a brilliant job with first-aid kits, which is a nice growth market.”

Century Communities

Housing sales have been surprisingly resilient this year, but construction is still running below new household formation implied by demographic trends. Century Communities (CCS), a home builder in the Mountain, West, and Southeast regions, should be a beneficiary of demand for entry-level houses. Its sale price of homes delivered has averaged $314,000 this year, and a third of sales come from houses priced at $162,000. “They’re capitalizing on a movement to low-cost housing,” says Bill Nasgovitz, chairman of Heartland Advisors, a value-investing firm. Single-family home construction remains well below historic averages, he adds, which supports prices, and demand should get a lift from low interest rates and a cyclical rebound in the economy.

Century is on track to deliver about 9,500 houses this year and 11,000 in 2021, up 16%. Despite a 51% gain in its stock this year, it still trades at only seven times estimated 2021 earnings of $6 a share. Profits are expected to increase 18% next year, giving the stock a low P/E-to-growth ratio of 0.4. “The exodus from metro areas will continue,” says Nasgovitz. “Low rates will be with us for quite a while, and housing affordability is there,” all of which should support demand for houses and Century’s products.

Atlas Air Worldwide

Atlas Air Worldwide Holdings (AAWW) is one of the few airline stocks to fly higher this year. Why? Atlas isn’t a commercial airline; it transports cargo from Asia and other regions to the U.S., and revenues have spiked as commercial airlines cut back on flights, reducing cargo loads on passenger planes.

Royce’s Hench argues that Atlas has a strong position in three core markets: transport for fast-growing e-commerce, express services, and traditional air freight. Atlas is also getting a lift from Amazon, which owns 1.3 million shares, or 5% of the outstanding stock, and has warrants to acquire up to 40% of the shares. Atlas’s operating deal with Amazon is also expanding: Atlas now operates eight Boeing 737 freighters for Amazon, after adding three planes since September to handle more cargo, and operates additional 767 aircraft for the e-commerce giant.

Atlas stock took a 10% hit on news of Pfizer’s Covid vaccine. Airlines could rapidly ramp up commercial flights, expanding freight capacity, and they have been operating more cargo-only flights. Delta Air Lines (DAL), for instance, is now operating 20 international cargo flights a week. But analysts are already pricing in revenue and profit declines for Atlas: the cargo carrier is expected to earn $11.76 a share this year, declining to $8.64 next year.

Even so, the stock looks inexpensive at six times estimated 2021 earnings. Hench isn’t expecting a steep drop in freight rates, given strong demand trends and potential for new revenue streams, including airlifts of a coronavirus vaccine. “The industry could get a benefit from the vaccine as it could take up freight capacity,” he says. “As far as other potential surprises, an economy getting back to normal would benefit Atlas.”

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