SMALL CAPS

 

What is a small-cap stock?

Generally, small-cap stocks are those with a market capitalization within the $300 million to $3 billion range, although the market-cap parameters are not set in stone.

What types of companies fall into the small-cap asset class? 

Bradley Needham & Co man believe Small-capCompanies can come from any industry or sector. But most small-cap growth companies are innovative. They frequently emerge from an inspiring pioneer's invention or plan to do something that has never been done before, and they tend to launch businesses in new and untested markets, define and develop a market niche or breathe life into products and services that leverage new or emerging technologies. Many fall into the technology, health care and consumer discretionary sectors, which in many ways represent the economy of tomorrow and are among the fastest-growing companies today.

What's the difference between small-cap growth and value?

Small-cap growth stocks represent companies that exhibit strong growth characteristics, like annualized sales and revenue growth of 30 percent or higher, and generally are less reactive to changes in the overall economy.

In contrast, small-cap value stocks are viewed as being undervalued relative to their peers, as well as inexpensive based on fundamentals such as book value, cash flow, earnings per share and sales.

What are the pros and cons of investing in small-caps?

Small cap companies' smaller size, shallower financial resources and narrower market focus mean there can be less room for error. Smaller companies are not immune from — and in some ways can be more vulnerable to — broader market and economic gyrations if those forces impact their specific markets and customers.

But with that risk comes opportunity, as investors willing to assume the added risk of investing in small-cap companies may be rewarded for the extra risk associated with this asset class. This risk-premium factor reflects their potential to outperform larger asset classes over time.

What market environment do small-caps generally thrive in?

With earnings growth, tax reform and the outlook for more IPOs, now is a good time to consider adding small-cap companies to your portfolio.

After a multi-year lull, corporate profits have rebounded strongly and are projected to move even higher this year as consensus estimates continue to trend up. Plus, the dramatic lowering in the top-line rate may provide a bigger boost to small caps, most of which had been paying a higher effective rate than some large corporations.

Finally, among the catalysts for this year's IPO market are the anticipated debuts of companies which represent the underlying forces of innovation that can be a powerful driver for long-term growth, and an area where small-cap companies are thriving.

Given the current supportive environment, small-cap growth stocks offer greater opportunity for potentially better long-term, risk-adjusted returns than larger cap or other asset classes. A willingness to accept the volatility might mean, for the mall cap investor, that opportunitiesabound.

6 Things You Need to Know About Small-Cap

Volatility can give you a clue

Despite its wild finish, 2Q18 was still markedly more bullish and less volatile than 1Q18—it also saw a shift in small-cap style leadership that we’ll be watching closely 2Q18—Lower Volatility, Higher Returns

Although it finished on a wild and bearish note, 2Q18 was both markedly more bullish and less volatile than 1Q18. The quarter also saw a late shift in style leadership within small-cap that bears watching.

Returns for U.S. stocks were solidly positive in spite of several challenging developments, including tariff and trade war talk, a strengthening dollar, market and economic softness in China, slower growth in Europe, and negative news out of Brazil and Argentina.

To varying degrees, all of these developments conspired to make the last weeks of June 2018 by far the most volatile of the entire second quarter.

And while results for the major domestic stock indexes were positive in the face of the late downward pressure, most international indexes slipped deeper into correction mode during 2Q18. Indeed, the combination of a modest slowdown in international growth, rising emerging market instability, a stronger dollar, and heightened trade war concerns led investors to prefer all things domestic.

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Smaller Was Better

The headlines were arguably more volatile than the markets through most of 2Q18. To be sure, much of the fundamental news was positive. Economic growth in the U.S. continued to accelerate, while most companies continued to post excellent earnings, aided by lower tax rates.

Their greater reliance on U.S. growth left small- and micro-cap stocks much better positioned for superior performance relative to large-caps in the quarter. Another related plus for small-caps was the strengthening dollar, which has often coincided with relatively stronger small-cap results in the past.

All of this made smaller better across the market cap spectrum. Performance was best in 2Q18 for micro-caps, followed by small-, mid-, and large-caps.

As much as domestic economic growth helped to drive results, some of small-cap’s relative advantage can also be attributed to cyclicality and reversion to the mean: both the Russell 2000 and Russell Microcap Indexes underperformed the Russell 1000 Index for calendar 2017 before beginning to move past large-caps earlier in 2018.

Value Makes a Late Move, Tops Growth

Based on a strengthening U.S. economy and related widespread corporate profit growth, it made sense that the Russell 2000 Value Index finished 2Q18 ahead of the Russell 2000 Growth Index.

It was also not surprising that small-cap breadth expanded in the quarter. The equal-weighted Russell 2000 outperformed the capitalization-weighted index, and in doing so reversed another trend from 1Q18.

What was surprising was that more defensive sectors led, rather than those more economically sensitive areas (more on that below).

Whether or not value’s leadership is a more lasting shift, of course, remains to be seen. Having gone through a few favorable moves for value over the last few years that proved short-lived, we are simultaneously wary and optimistic.

It seems clear to GPS that the stage remains set for a longer outperformance phase for small-cap value. The combination of economic growth, rising interest rates, and value’s long-term historical advantage all argue strongly in favor of a more sustained period of leadership.The conundrum is that these conditions have been present for the last year-and-a-half—a period in which growth has led in five of six quarters.

Energy Hits the Pedal

The top-performing sector in the Russell 2000 was Energy by a significant margin, as the rebound in commodity prices and production made a positive impact on stocks in both the oil, gas & consumable fuels and energy services industries. Defensive sectors Consumer Staples and Real Estate rounded out the top three. These areas were three of the index’s four worst performers in 1Q18, along with Consumer Discretionary, which also came back strong in 2Q18.

It’s also likely that Consumer Staples, Real Estate, and Consumer Discretionary looked particularly attractive to investors anxious about international growth because all three derive a higher-than-average percentage of their revenues from domestic sources.

Bradley Needham & Co man suspect that the sector leadership of Consumer Staples and Real Estate will be short lived as each is more interest-rate sensitive and less responsive to a stronger economy, which is precisely the opposite of how we think portfolios should be positioned going forward.

Cyclicals in Neutral

Perhaps the most unexpected result of the quarter was the ongoing lackluster performance for two key cyclical sectors, Industrials and Materials, which sat at the bottom of the small-cap sector performance standings.

Both faced headwinds—dollar strength often leads to weaker commodity prices, which especially hurts Materials, and European growth fell off from its previously fast pace. Moreover, trade war anxiety and a weakening Chinese economy provided additional rationales for investors to be cautious with these stocks—or avoid them completely.

Bradley Needham & Co are on the opposite side of this pessimistic assessment. Our contrarian confidence comes from meetings with company managements who are communicating greater assurance and optimism than we have heard in some time. Their positive expectations are consistent with both PMI (Purchasing Managers’ Index) and ISM (Institute of Supply Management) numbers that continue to show strong manufacturing, production, and order trends here in the U.S.

Thus, GPS believe that some of the most undervalued opportunities within the asset class can be found in these low-expectation cyclical sectors—many of which boast what we think are excellent earnings and cash flow profiles.

Bradley Needham & Co man Perspective: Lean Cyclical and Stay Active

Particularly in an era of rising interest rates, we are sticking with the view that select small-cap cyclicals with solid balance sheets are best positioned for small-cap leadership.

Bradley Needham & Co man see stronger earnings and cash flow prospects in several cyclical industries than we do in growth and/or defensive areas—as well as confident management teams.

We think it’s worth noting that the three changes in the market environment that we expect—lower returns, higher volatility, and value leadership—have all historically been coincident with active management leadership.

2017 to 2018 provided some enticing glimmers of further progress on the long road to normalization, most notably via modest increases in bond yields and the reemergence of value’s leadership. We anticipate that other aspects of normalization will emerge as the year goes on.

How to Find Small-Cap Stocks in Five Steps

The numbers don’t lie: small-cap stocks are, historically, better performers than large-cap stocks.

The average annual return in the S&P 600 Small-Cap Index over the past 20 years is 10.5%, compared to a 7.9% annual return in the S&P 500 during that time. Whether you were aware of that statistic or not, you’ve probably been tempted to invest in small caps at some point.

But one thing has prevented you from doing so; you don’t know how to find small-cap stocks – or at least the right small-cap stocks.

Bradley Needham & Co man are always looking for companies that are pioneers in their areas of business. In many cases, these companies are creating whole new micro-industries, providing essential tools for an entire industry’s growth, or doing something better or faster than in the past.

But we don’t like to discount traditional businesses. A lot of very successful small-cap investments come from very basic business models. The corner convenience store, the healthy food manufacturer, the high-volume concrete company … a lot of money can be made by keeping things simple.

The common thread will always be that Bradley Needham & Co see 100% or greater upside with each stock within a two-year time frame.

Because, it is institutional investors who drive up stock prices, we look for the same thing they look for, but because GGS is seeking far greater returns, our approach must be different. Bradley Needham & Co forensic research digs significantly deeper into the industry and company to uncover information that gives our clients a unique advantage.

Getting more specific, there are a few steps that we follow:

How to Find Small-Cap Stocks in Five Steps 

1. Search for paradigm shifts that are opening up new opportunities.

Try to search for paradigm shifts in any field of business that requires a unique, new solution that will be provided by a stand-alone company. Try to seek a niche supplier that will become an equal benefactor to that pioneering company. We call these companies “pure plays.”

A good example of such a paradigm shift was the move from the mainframe computer environment to the personal computer environment in the 1990s. All the new personal computers needed to be connected! And Cisco (CSCO) filled the void, supplying the industry with networking tools and its stock increased 70-fold.

Another example was the move from CD to DVD format. Sonic Solutions (SNIC) provided the software for conversion to the new DVD format and its stock took off. In the consumer market, energy drinks burst on the scene in the late 1990s, giving the industry its first truly new product in decades. Hansen Natural (HANS) stepped in to become the leader and its stock, now renamed Monster Beverage (MNST), has been one of the best performers of the post-2002 bull market.

Bradley Needham & Co try to dig deep to uncover the small company suppliers to the transition leaders—just as the top suppliers to Cisco, Sonic Solutions and Hansen became equal beneficiaries of the paradigm shifts, yet remained largely unnoticed by institutional investors until well into their industry transitions.

2. Invest only when the market opportunity is huge—and quantifiable

This is the Law of Large Numbers: Only invest in small companies that serve large, burgeoning markets because the companies can realize tremendous growth with even small market share. The sheer size of the markets creates the potential for huge gains while helping to reduce your risk profile.

Large medical patient populations and new technology users are examples of vast markets to target. Here’s an example: By the age of 60, half of all men will have an enlarged prostate, a condition known as Benign Prostatic Hyperplasia (BPH).

Research tells us that treatment for this condition will cost upward of $10 billion per year. The opportunity for a small company that captures even a fraction of this market would be enormous.

3. Invest in companies before the institutions notice them

This strategy is called robbing the train before it arrives at the station. By gaining a research advantage, we can invest in companies before most big investors get on board—including mutual funds, hedge funds and pensions.

In many cases, our customers will invest in companies that have less than 50% institutional ownership. The idea here is that subsequent investments by institutions will drive up the value of the stock.

4. Invest in stocks that offer both growth and value

Big, growth-oriented ideas are awesome, but it’s also important to consider valuation and buying when valuation as compared to peers is reasonable. A good candidate may be a young company that has demonstrated significant growth in sales, yet is undervalued based on the company’s market potential versus its total market capitalization.

Bradley Needham & Co man also want to see a balance sheet with cash and little, if any, debt. Cash is important because it can carry a company through unexpected events. For example, should the much-anticipated launch of a product be delayed, we want the company to have enough cash available to see the product to market.

5. Avoid big losses

It’s last on our list, but certainly far from my least important rule for how to find small-cap stocks.

Since 1925, small-cap stocks have posted greater gains than any other asset class—2% to 5% a year more than mid caps and large caps. And between September 2011 and September 2015, small caps rallied by 20% more than large caps, posting a total return of 97%.

That long-term outperformance helps to make a strong case for owning small-cap stocks.

But investors do need to understand that the larger moves to the upside are typically mirrored on the downside during bear markets and market corrections.

As a general rule, small caps are more volatile than large caps, but less volatile than emerging markets stocks. This isn’t reason to steer clear, it just means that you should expect larger swings in their prices, and you should use stop losses to avoid really big losses.

Many advisors advocate a 10% to 15% stop loss for large caps. For small caps, I like to widen this to 25% to 30%. The reason is that we often see quality small caps drop 20% or so during market corrections. And often, these are the times to buy, not to sell. We don’t want to get chased out of a quality stock because of market volatility.

If a small-cap stock falls by 25% from my entry point, I start to watch very, very closely. The critical thing to do at this point is determine if the decline is due to some fundamentally negative event, or trend, that undermines the company’s longer-term potential, or if it is simply the result of market turbulence.

If it is the prior, then the stock is more than likely a candidate to sell. While turnaround stories do happen, the bottom line is that investors need to cut losses short on bad stocks that continue to fall.

If it is the latter, it may make sense to give the stock a little more wiggle room, and see if it hits that 30% stop-loss level. If it does, then at that point it really is a matter of watching extremely closely for a good exit point.

The idea here is to avoid catastrophic losses. A couple of 30% or so losses a year is not a big deal. But allowing those losses to get bigger really does curb the overall profit potential of your portfolio.

Ultimately, you’ll need to decide what stop loss level works for you, and what will make sure you sleep well at night.

Here’s how to find those hidden small-cap gems
  • After negative returns in 2015, small caps delivered in both 2016 and 2017, as the S&P Small Cap 600 Index returned 26.5 percent and 13.32 percent each year, respectively.
  • Small caps are immune to trade-war fears, economic expansion increases earnings more down cap than up and delayed benefits of the tax cut should help domestic-centric companies.
  • Pay close attention to volatility, use new online tools for research, find out how much attention people are paying to an opportunity, and don't be afraid to think local or regional.

Small-cap indexes have been rising in recent years, and many outlooks for 2018 are rosy. Yet indexes aside, greater opportunities this year may await investors who can identify promising small companies laboring in relative obscurity.

After negative returns in 2015, small caps delivered in both 2016 and 2017, as the  S&P Small Cap 600 Index returned 26.5 percent and 13.32 percent each year, respectively. The index's one-year trailing returns as of this May 2 totaled 13.56 percent. And some forecasts call for 18 percent to 20 percent growth this year, ahead of large caps.

Buttressing optimism for the category is its immunity from the market's trade-war fears: Small companies don't tend to export much. Another factor is the tendency for economic expansion to increase earnings more down cap than up. Further, the delayed benefits of the tax cut should help domestic-centric companies proportionately more than multinationals. Small caps, which tend to pay higher effective tax rates, receive proportionately more tax relief from the legislation.

These factors doubtless will provide an extra boost for small companies that are already on the rise — and benefit investors looking for value in individual stocks. In a market where investors are constantly assaulted by data on large caps, many small companies aren't widely known. This makes them perennial fodder for the craft and sullen art of astute stock pickers seeking to exploit market inefficiencies. Typically, small caps on the launching pad or even taking off receive little or no touting from Wall Street, whose sell-side analyst ranks are thinning because of investment flows from active to passive management.

An estimated 45 percent of small-cap companies now have no analyst coverage whatsoever, and only about 20 percent have as many as five analysts covering them. And because of liquidity constraints, large small-cap funds tend to limit their purchases to larger small companies with sufficient trading volume — those with market caps above $500 million. Though these may not be covered by any analysts, inclusion in large funds can bring attention, while smaller small caps have a much lower profile. The paucity of analysts covering these companies is doubtless slowing the already glacial speed of information about them.

For individual investors, the resulting market inefficiencies come with a conundrum. If news about the merits of potential winners travels slowly, how can they learn about it before it pushes up prices? How can they find and evaluate small companies that may be prospering, unbeknownst to most of the market?

Here are some moves to consider in the search for those hidden small-cap gems.

1. Pay especially close attention to volatility. Volatility can be friendly to small-cap value investors. If past periods of high volatility hold true, this year's herky-jerky market will likely foster a repeat of the baby-out-with-the-bathwater effect, in which lower trading volume punishes price disproportionately for small companies. This can create value opportunities for informed investors lying in wait for price dips.

2. Learn to use new tools available on low-profile radar screens. Some online screens providing myriad data are free of charge. To that point, CNBC.com has a free stock screener that's highly configurable. For example, an effective search for high-performing small companies with low profiles could use these five screens:

  • Market cap under $500;
  • Year-over-year revenue growth greater than 10 percent;
  • One-year EPS growth greater than 15 percent;
  • P/E ratio of 15 or less; and
  • Coverage by two or fewer analysts.

In early April, these criteria produced 19 companies that are good candidates for closer analysis, depending on your goals and asset allocation. Other online tools can be purchased for reasonable annual subscription fees (in the low three-figures per year), making them sensible for individuals making sizeable allocations to small caps. Some provide aggregate performance scores reflecting various multiples.

3. Find out how many people are paying attention. Even if an otherwise attractive small company seems to have a relatively high level of analyst coverage, try to get a handle on how widespread market awareness of this company might be. How long a Google results queue does a company name generate?

If the Web profile seems low compared with those of other small companies, there's a good chance that few investors are going to learn of its emerging ascendance at least until the next quarterly earnings report or the Securities and Exchange Commission's Form 8-K, the latter being filed in the event of material change greatly enhancing profit potential.

4. Don't be reluctant to think locally or regionally. To the extent that filings trail results, observant locals may have better insights into small companies than people 1,500 miles away. Through local news media, you might learn of some promising new development, partnership or product before an 8K is issued or investors see nationwide news press releases on the PR Newswire.

This advantage over the rest of the country comes with a decided disadvantage — the potential for confirmation bias. Local companies, especially in labor-intensive industries, tend to be on the minds of local people and, to the extent that these companies have a good local image, you might fall victim to familiarity bias (as employees do when acquiring too much company stock without sufficient diversification). Don't confuse proximity with virtue.

5.The Russell 2000 hasn’t seen this kind of winning streak since 2013.

Pursue value opportunities unknown to most of the market:Small caps’ best win streak in five years is flashing a bullish signal to the S&P 500.Small caps' best win streak since 2013 is a bullish signal.

After showing eight straight weeks of gains this year, history suggests small caps are flashing a big buy signal to all stocks.

Bradley Needham & Co analysts took a look at future returns after these long weekly win streaks on the Russell 2000, sure enough small caps continued to do well. What’s more interesting, though, is the S&P 500 actually does a little bit better.

The past nine times the Russell 2000 had a winning streak that stretched over at least eight consecutive weeks, the S&P 500 posted an average 6.4 percent gain in the following six months. Over those same periods, the Russell 2000 added an average 4.3 percent.

Small-cap leadership is a good thing andit could be carving the way potentially for this bull market to continue as the S&P’s second half of the year also does well.

The underlying fundamentals, led by the best earnings growth since 2010, keeps Bradley Needham & Co bullish on the S&P 500 for the second half of the year.When you have double-digit earnings growth, the S&P is higher every single time since 1990 (12 out of 12 times),earnings drive long-term gains. So, stay with the bulls here led by earnings.

The S&P 500 is expected to post 21 percent earnings growth for the full year as tax cuts passed in December give rise to companies’ bottom lines. The second-quarter earnings season, also expected to show off double-digit gains, will kick off with the big banks in mid-July.

The Simple Reason Small Caps Are Surging in 2018

The S&P 600 Small-Cap Index broke out to an all-time high and eclipsed the 1000 mark for the first time in its 24-year history.



With this move small caps are now handily leading the market, posting a year-to-date (YTD) gain of 11.6% versus just 4.4% for the S&P 500. Even more impressive is the performance of certain small-cap sectors. For example, the small-cap health care, energy and tech sectors are up 30.6%, 10% and 11%, respectively.

The three most pressing questions for investors are: (1) What’s behind the run, (2) can it continue, and (3) where should you invest?

Let’s take these one at a time.

Bullish Trends Powering Small Caps in 2018>

Several big picture factors are collectively driving small-cap stock performance, including a good U.S. economy, decent growth in international markets, deregulation, and a positive impact from tax reform.

All together these positives are driving robust revenue and EPS growth and prompting analysts to push up forward growth estimates.While it took a few months for small caps to break out in earnest, these factors are all coming into play today as small caps break free.

Bullish Reason #1: Tax Cut & Jobs Act Disproportionally Beneficial for Small Caps

With the newly signed the Tax Cuts and Jobs Act into law last December the corporate tax rate was lowered from an average rate of 28% for large caps (S&P 500) and 32% for small caps (Russell 2000) to 21% for both. The average cut of 11% for small caps is much larger than the average of 7% for large caps. The impact is different for every company out there, and it’s a little early to point to tangible results. But in general, the tax rate appears to be raising the likelihood of reinvestment, stock buybacks, M&A activity, and higher earnings per share, all of which can be positive catalysts for small-cap stocks.

Bullish Reason #2: Small Caps Outperform During Economic Expansions

Data from Credit Suisse shows that since 1986, small caps have been up 100% of the time when GDP growth is in the 2% to 3% range. The latest estimates suggest GDP should be 2% to 3% in 2018, and current consensus has it above 2% in 2019 too. Bottom line – history shows that when GDP growth is in this range, it hasn’t paid to bet against small caps.

Bullish Reason #3: Small Caps Should Benefit from High U.S. Exposure

Remember that investing in small caps is like a leveraged play on the U.S. economy since roughly 80% of small-cap sales come from within the U.S. (compared to about 70% of S&P 500 revenues). With U.S. GDP estimates looking relatively strong, domestically-focused companies, which includes a large proportion of small caps, are doing well.

What’s the Best Way to Invest in Small-Cap Stocks?

Bradley Needham & Co man suggested the S&P 600 Index would finish the year up 12% to 17% and would outperform large caps in the process. To arrive at that range, I figured the index would be trading with a forward P/E of 19 to 20 at year end. Using the consensus EPS estimate at that time for 2019, which was $54.95, Bradley Needham & Co came up with an index value of 1045 to 1100.

The reason is simple. Over the last five months, industry analysts have raised their EPS estimates for 2019. The current consensus is for S&P 600 earnings of almost $62. That’s almost a 13% increase from where they were in January. Using that figure, our Bradley Needham & Co Bradley Needham & Co analysts’ forward P/E range of 19 to 20 at the end of 2018, yields an S&P 600 index value of 1178 to 1240.

That implies small caps have 13% to 19% upside right now.

For argument’s sake, let’s say S&P 600 earnings for 2019 are closer to $60 at year end. Slap a forward P/E of 19 on that figure and you get an index value of 1140. That implies small caps will have rallied 21% in 2018, and 9.5% from where they are now.

What’s the best way to capture this upside?

The easiest is to simply buy an ETF that tracks the S&P 600 Index. But, you should really consider owning the stocks

Bradley Needham & Co tries to put the odds in our customers favor by selecting stocks that have durable business models, solid management teams, good charts and compelling long-term growth. These are the types of stocks that have helped pushour clients’ our average portfolio gains.

Contact Us Learn more about a range of strategies for investing in small-cap opportunities.