By Jacob Sonenshine
High-growth, small-market-capitalization stocks have been shut out of the market rally for long enough. Being choosy should pay off, though.
The iShares Russell 2000 Growth exchange-traded fund is home to stocks with an average market cap of $6 billion that are expected to boost profits, in aggregate, faster than the S&P 500, Nasdaq Composite, and even the broad small cap indexes. The ETF is down 22% from its record high, hit in early 2021, while the Nasdaq has hit many new highs since then.
The main problem is higher interest rates, as the Federal Reserve lifted them many times over the past few years. Many of these companies are unprofitable, and reliant on raising money to fund growth until they make money. The increased cost of financing from higher rates lessens the appeal of future cash flows from business expansion, and some companies are in financial distress.
Even with indications that the Fed might cut rates soon, these stocks haven't gotten tons of traction yet. Rate cuts aren't a given, because inflation remains above the Fed's goal. Plus, Big Tech's artificial-intelligence dominance has hogged investor attention and money.
The good news is that small-cap growth fund has begun to show signs of life. The ETF is up more than 1% from a multi-month low set on June 14, outperforming the Nasdaq Composite's slight dip since then.
That's partly because valuations for the small-cap group have dropped enough that new money moving into growth names is likely to flow into the beaten-down areas. The growth ETF trades at just under 33 times forward-12-month earnings estimates, roughly half of its 2021 peak. The current multiple is also a mere 16% above the Nasdaq's 28.2 times, versus an average premium of almost 50% in the past five years, according to our calculations of FactSet data.
The key is discerning the most promising small-cap-growth stocks. After all, the group as a whole may struggle for a bit since the market doesn't fully trust the narrative that rates are about to aggressively fall.
To that point, Trivariate Research screened for the small-cap-growth companies that have recently seen higher profit margins and free cash flow versus their historical averages, but have traded with lower betas versus their histories. Beta is a stock's volatility versus the market's volatility. The idea is to find stocks with lessening downside if the entire market drops, but that have strong upside because of their fundamentals.
Stocks on the screen include Yelp, which has a $2.4 billion market valuation, and the $1.8 billion Powell Industries, which manufacturers custom-engineered products and systems for energy and utility companies. Another is $3.7 billion Simply Good Foods Company, which makes shakes and nutrition bars such as Quest. Euronet Worldwide is a $5.1 billion payment and processing provider. GMS is a $3.3 billion distributor of walling and ceiling systems for interior construction.
There's also Commvault Systems, a $5.5 billion provider of cybersecurity software that helps businesses protect against threats such as ransomware. The majority of its expected $895 million 2024 revenue according to FactSet is subscription-based. It competes with a crowded field of players, including International Business Machines and Dell Technologies, but it has grown sales from less than $304 million in 2010.
Plus, since it's never incurred more than $100 million annually in cost of revenue, it's an inherently profitable business. That gave the company the flexibility to produce a 21% operating margin last year.
Profits will grow briskly, as analysts expect sales to grow in the low double-digit percentage annually though at least 2026. Margins may not improve much because of stepped-up selling, marketing, and research spending, but the company doesn't need to borrow additional money. That's why the revenue growth should spur annual bottom-line growth of 15% through 2026.
Big things could eventually come from these small stocks.
Write to Jacob Sonenshine at jacob.sonenshine@barrons.com
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(END) Dow Jones Newswires
June 28, 2024 21:30 ET (01:30 GMT)
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