10 small-cap stocks selected by digging deep for quality

Dow Jones10-19

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 19, 2024 07:10 ET (11:10 GMT)

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