MW 10 small-cap stocks selected by digging deep for quality
By Philip van Doorn
David Trainer explains how New Constructs incorporates decades of information buried in companies' financial statement notes, for "better" calculations of returns on invested capital
Small-cap stocks as a group are less expensive than large-cap stocks, whose valuations to expected earnings might be considered stretched at this point in the bull-market cycle. But there are different approaches to tracking small-caps as a group, and a quality approach might be best for long-term investors.
Below is a screen of stocks in the S&P Small Cap 600 Index SML, based on returns on invested capital as calculated by New Constructs, a data provider founded by its chief executive David Trainer in 2002. Trainer explained how his firm's automated data process encompasses companies' financial and accounting moves over the long term, to make its calculations of returns on invested capital more accurate than they might be if done in the traditional manner.
Trade or invest?
On Monday in the Need to Know column, Jamie Chisholm outlined a trading strategy described by Jeff Jacobson of 22V Research, centered on the Russell 2000 Index RUT. Jacobson pointed out that during second-quarter earnings season, the iShares Russell 2000 ETF IWM rose 9.4% from July 10 through July 30, while the Invesco QQQ Trust QQQ fell 9% (both excluding dividends). QQQ is an exchange-traded fund that holds the 100 largest nonfinancial stocks in the Nasdaq Composite Index COMP. Do QQQ is heavily weighted to large technology companies, such as Apple Inc. $(AAPL)$, Nvidia Inc. $(NVDA)$ and Microsoft Corp. $(MSFT)$, which together made up 24.8% of the ETF's portfolio as of Oct. 11.
Jacobson expects to see a similar rotation away from Big Tech and toward small-cap stocks this earnings season. He described a specific trading strategy to play along.
But not all investors are traders. According to Jacobson, the widening of the bull market to a larger number of stocks and the Federal Reserve's change in policy that began with its reduction of the federal-funds rate by 50 basis points last month, bode well for smaller companies. Broad small-cap indexes also trade at lower price-to-earnings valuations than large-cap indexes. Another argument in favor of small-caps for longer-term investors is diversification away from the S&P 500 SPX, which like QQQ is heavily weighted to Big Tech.
A higher-quality small-cap index
The Russell 2000 Index is often cited as an appropriate benchmark for small-cap stocks. It is made up of the 2,000 smallest stocks in the full Russell 3000 Index RUA by market capitalization. The Russell 3000 itself is designed to capture 98% of the market value of publicly traded U.S. common stocks.
But the Russell 2000 has no other selection criteria. It includes more than 800 companies whose combined earnings per share for the past four quarters have been negative, according to data provided by FactSet.
A more selected approach is taken by Standard & Poor's with the S&P Small Cap 600. Among this index's criteria for initial inclusion are four consecutive quarters of profitability.
Here is a comparison of total returns for various periods (with dividends reinvested) through Monday for the iShares Core S&P Small Cap ETF IJR, which tracks the S&P Small Cap 600, and the iShares Russell 2000 ETF:
ETF 1-year return 3-year return 5-year return 10-year return 15-year return 20-year return
iShares Core S&P Small Cap ETF 30.0% 8.9% 65% 167% 430% 538%
iShares Russell 2000 ETF 32.5% 2.8% 59% 142% 340% 418%
Source: FactSet
And here are average annual returns:
ETF 3-year avg. return 5-year avg. return 10-year avg. return 15-year avg. return 20-year avg. return
iShares Core S&P Small Cap ETF 2.9% 10.5% 10.3% 11.8% 9.7%
iShares Russell 2000 ETF 0.9% 9.7% 9.2% 10.4% 8.6%
Source: FactSet
The more selective approach of the S&P Small Cap 600 has outperformed the Russell 2000 for all periods except for the one-year period through Monday. So this group of 600 stocks was the initial group for our new screen of this part of the U.S. stock market.
New small-cap stock screen - ROIC
The traditional definition of a company's return on invested capital $(ROIC)$ is its profit divided by the sum of the carrying value of its common stock, preferred stock, long-term debt and capitalized lease obligations.
ROIC is meant to indicate how efficiently a company's management team has allocated investors' capital. It isn't necessarily a fair way to compare companies across industries, because some industries are more capital intensive than others.
Digging further into ROIC, the carrying value of a company's stock may be much lower than its current market capitalization. The company may have issued most of its shares many years ago at a price much lower than the current price. If a company has issued a relatively large amount of newer shares recently, or at high prices, its ROIC will be lower. If a company has low debt, its ROIC is higher. If a company is being forced to increase borrowings, especially when interest rates are high, its ROIC will go down.
During an interview with MarketWatch, David Trainer explained that one of the reasons he and his team had been "meticulously marking up" corporate filings since New Constructs was founded in 2002 was to retain data that might be lost over time. The idea is to arrive at a "better" calculation for ROIC, he said.
For example, if a company raises money to acquire other companies, its capital will increase and its return on invested capital will go down. The acquiring company's management team expects the new acquisitions will make it more profitable over the long term.
But if the company later writes down the value of the acquired assets, it may book a net loss at that time, which lowers its ROIC temporarily. But the accounting treatment is such that the invested capital that was written down is no longer included in ROIC calculations. Write-downs can boosts ROIC over time.
Trainer summarized the concept: "When something is written down, it disappears. There is a charge on the income statement at that time. What we do is take it out of the income statement, and leave it as part of total invested capital."
In other words, the "proper definition" of invested capital is "all the capital that has been invested in a company over its lifetime," he said.
Trainer suggested that when investors use ROIC numbers, they ask their data providers if accumulated write-downs are included. "That is what we do in the notes better than anyone else," he said, referring to information that is available in the notes below corporate financial statements in corporate filings with the Securities and Exchange Commission. A detailed explanation of how New Constructs calculates ROIC is available here.
For the ROIC numerator, New Constructs makes adjustments to calculate net operating profit after tax. This excludes extraordinary items that can raise or lower reported profits.
For this new screen of small-cap stocks, we started with the S&P 600 and narrowed the list to 543 companies for which New Constructs was able to provide five-year average ROIC. New Constructs calculates ROIC for the previous four reported fiscal quarters. So these are averages for the past five 12-month periods, using the most recent available quarterly data for each company.
Out of the 543 companies, New Constructs rates 30 of the stocks "very attractive."
Among the 30, these 10 companies have had the highest average ROIC over the past five years, as calculated by New Constructs:
Company Ticker Industry 5-year average ROIC Market cap ($mil) USANA Health Sciences Inc. USNA Skincare products 40.0% $679 The Buckle Inc. BKE Apparel retail 35.1% $2,187 Virtu Financial Inc. VIRT Brokerage and trading services 31.1% $2,851 Warrior Met Coal Inc. HCC Coal 30.6% $3,389 Arch Resources Inc. ARCH Coal 24.0% $2,641 Mr. Cooper Group Inc. COOP Residential Loan Servicing 22.7% $6,199 Gogo Inc. GOGO Wireless telecommunications 22.0% $891 Cal-Maine Foods Inc. CALM Food production and distribution 21.2% $3,981 Meritage Homes Corp. MTH Residential construction 20.2% $7,147 Tri Pointe Homes Inc. TPH Residential construction 18.9% $4,198
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October 15, 2024 12:14 ET (16:14 GMT)
MW 10 small-cap stocks selected by digging deep -2-
Sources: New Constructs (ROIC), FactSet (market cap), company filings.
"The ratings are a measure of risk/reward for stocks based on quality of earnings and stock valuations," Trainer said. The profitability component a company's rating is ROIC less the company's average cost of capital. Here is a guide to the New Constructs stock ratings system.
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If you see any companies of interest on the list, or are interested in any of the ETFs mentioned in this article, you should do your own research to form your own opinion before making any investment. One way to begin that process is by clicking on the tickers for more information.
Click here for Tomi Kilgore's guide to the wealth of information available for free on the MarketWatch quote page.
Don't miss: The S&P 500 is too tech-heavy. This alternative ETF keeps beating it.
-Philip van Doorn
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