A Rare Buying Opportunity Before A Big Market Reversal Takes Place

seekingalpha06-23

Peter Lynch recently observed that the market has been behaving very abnormally recently, creating a rare and incredible buying opportunity.We discuss why this is.We also share some of our top picks ...

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Data by YCharts As a result, famous investor Peter Lynch commented that \"we've been in an incredible bear market for two years\" if you simply exclude the leading mega-cap stocks like Apple (AAPL), NVIDIA (NVDA), and Microsoft (MSFT). Like Peter Lynch, I believe this presents an incredible opportunity as it is rare to be able to buy high-quality, smaller-sized businesses at very attractive valuations and set yourself up for significant outperformance in the coming years without having to take on much long-term risk in the process. In this article, I will detail why. The Long-Term Outperformance of Small Caps First of all, small-cap stocks have typically outperformed large-cap stocks over the long term. This is because small-cap stocks generally have much greater growth potential since large-cap stocks have to deal with the law of large numbers, making it harder for them to continue growing. Their businesses are generally more mature and often get weighed down by bureaucracy and inefficiencies that come with being a huge organization. In contrast, smaller companies are often hungrier, more focused on their mission, earlier in their development cycle, and have much more low-hanging fruit that they can capitalize on to grow their size. Additionally, small-cap stocks are easier to acquire and therefore often benefit from buyout premiums for quick returns. Current Market Conditions The recent bifurcation in market performance is unusual given the fact that historically, small-caps have outperformed large-caps over time, and therefore, reversion to the mean seems likely. There are other reasons to be bullish on small caps right now as well, especially relative to large caps. First and foremost, small caps generally outperform large caps when rates fall. A big reason why small caps underperformed large caps in recent years is because sharply rising interest rates caused investors to flee what they perceived as riskier smaller companies in favor of the safety of large blue-chip businesses. As a result, with the Fed likely at peak rates, we expect the Fed to begin cutting rates in a meaningful manner within the next year or two, which should serve as a tailwind for small-cap stocks relative to large-cap stocks. Additionally, the bull market in the megacaps has made them overvalued by virtually every evaluation metric. In contrast, many small caps look very discounted relative to their historical averages, especially if you expect interest rates to fall in the coming years. Large-cap stocks have their rich valuation premiums largely due to bullish expectations for artificial intelligence. However, virtually every sector will benefit from AI over time, and small-cap stocks currently have none of that benefit priced in. This presents a substantial opportunity, as mega-cap stocks may have too much optimism priced in for expected AI benefits. Another reason to like defensive small caps right now is that they should withstand stagflation better than many other businesses as their stable cash flows enable them to weather an economic downturn fairly well, and their smaller size and higher growth rates enable them to continue to grow cash flows rapidly, even if inflation remains somewhat elevated for the foreseeable future. Particularly if the Fed begins to cut rates, many of these smaller companies will benefit from a lower cost of capital, which should help offset any inflationary headwinds. Top Small Cap Picks With these views in mind, here are some of my favorite small-cap picks at the moment: BSR REIT (OTCPK:BSRTF) BSR REIT trades at a deep discount to its net asset value (NAV), as well as a meaningful discount to its larger-sized multifamily REIT peers. For example, BSR REIT currently trades at a 31% discount to its NAV, meaning that investors can buy a quality, well-diversified portfolio of multifamily real estate in markets with some of the best population growth outlooks at a steep discount. Additionally, it is backed by a conservative balance sheet and management that is prudently allocating capital to buy back discounted shares, with large insider ownership. Comparatively, larger blue chips like Mid-America Apartment Communities (MAA) trade at just an 8% discount to NAV, Camden Property Trust (CPT) at a 9% discount, AvalonBay Communities (AVB) at a 1% discount, Essex Property Trust (ESS) at an 8% premium, and Equity Residential (EQR) at a 4% discount to NAV. As a result, BSR REIT offers phenomenal upside potential without taking on much additional risk relative to larger peers. EPR Properties (EPR) EPR Properties is well-diversified across triple net lease properties with contractual rent increases. In addition, it is performing fairly well right now, as it recently grew its dividend by 4.5% and offers an attractive 8.34% dividend yield with an investment-grade balance sheet. Moreover, EPR is diversifying away from its weakest property type (theaters), and even these are generally well-located and profitable. Yet, it trades at a substantial 19% discount to its NAV. In contrast, Realty Income (O), whose market cap is about 15 times larger than EPR's, has a 5.9% dividend yield, is growing at a slower pace, and trades at a smaller 7% discount to its NAV. Realty Income's properties may be higher quality, and its tenants generally stronger, but the difference in yield, dividend growth, and discount to NAV are substantial, offering a remarkable opportunity with EPR. Patria Investments (PAX) Patria Investments has been growing its assets under management and distributable earnings rapidly as an alternative asset manager that is increasingly dominant in Latin America. Moreover, it expects to continue growing at a high-teens or even 20%+ annualized rate for the next several years, faster than its larger peers like Blackstone (BX). Yet, it trades at an incredible 9% expected next 12-month dividend yield and a mere 7.9 times price-to-earnings ratio, compared to Blackstone's 24.2 times price-to-earnings ratio and 3.5% dividend yield. While Blackstone is a lower risk due to its global diversification and massive scale, Patria's discount seems exorbitant, especially because Patria is growing faster than BX is and does not have any China exposure whereas BX has pretty substantial China exposure. Investor Takeaway Investors who are willing to take on a little bit of incremental risk have the potential to generate incredible outperformance by going with small-cap stocks over large-caps. In the case of Patria Investments, it could be argued that it's lower risk in some ways due to its easier path to strong growth rates in Latin America and lower geopolitical risks compared to Blackstone. The same can be said for EPR Properties, which is actively improving its portfolio quality, while Realty Income is moving into less familiar industries and new continents like Europe. Given the large market bifurcation, I am aggressively trying to take advantage of it to set myself up for outsized risk-adjusted returns by buying undervalued small-cap stocks with strong balance sheets and stable cash flows, while maintaining diversification with some large-cap stocks as well.  Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.","kind":null,"is_publish_news":true,"is_publish_highlight":false,"is_publish_live":null,"is_publish_wemedia":null,"editions":null,"column":"","sentiment":"","news_tag":"","news_rank":0,"symbols":[],"gpt_button":1},"commentList":[],"isCommentEnd":true,"newsSizeData":{"likeSize":0,"commentSize":0,"repostSize":0,"favoriteSize":0,"likeStatus":false,"favoriteStatus":false},"APP":{"userAgent":"Mozilla/5.0 AppleWebKit/537.36 (KHTML, like Gecko; compatible; ClaudeBot/1.0; +claudebot@anthropic.com)","isDev":false,"isTTM":true,"deviceId":"web-server-community-laohu8-v3","version":"4.24.2","shortVersion":"4.24.2","platform":"web","vendor":"web","appName":"ttm","isIOS":false,"isAndroid":false,"isTiger":false,"isTHS":false,"isWeiXin":false,"isWeiXinMini":false,"isWeiBo":false,"isQQ":false,"isBaiduSwan":false,"isBaiduBox":false,"isDingTalk":false,"isToutiao":false,"isOnePlus":false,"isHuaWei":false,"isXiaomi":false,"isXiaomiWebView":false,"isOppo":false,"isVivo":false,"isSamsung":false,"isMobile":false},"href":"/m/news/2445059040"}