By Jacob Sonenshine
Small market-capitalization stocks have failed to sustain any rallies. It is time for investors to shift their strategy on how to approach them.
The S&P Small Cap 600 Index, which spans all sectors of the market, rose 16% from its lowest point this year in April to a 2024 closing high of 1442, hit this month. The gains came in a series of brief rallies triggered by surges in confidence about the economy.
Factors that have fueled the moves include the fact that the Federal Reserve aggressively cut interest rates in September, while the economy has continued to grow at percentages in the low single digits. At the same time, former President Donald Trump's chances of winning reelection have risen in recent weeks, raising expectations that there might be additional tax cuts.
The problem is that the rallies have petered out like clockwork. Several times, there have been no more buyers to push the S&P 600 higher when it has neared its 2024 highs. The record close of 1465, hit in late 2021, is a few percent away, and it feels like a long shot.
Why can't the index, much less concentrated in high-growth technology companies than the S&P 500, power ahead? It remains historically cheap versus the S&P 500, so any development that makes continued growth in sales and earnings more likely should send it higher.
Interest rates represent a large part of the problem. A strong economy and additional government spending, either under a Trump or a Kamala Harris administration, could keep inflation above the Fed's 2% goal, discouraging the central bank from cutting rates. That could ultimately slow down the economy. And smaller companies currently have more variable-rate debt than large-caps, so they stand to see earnings drop disproportionately when borrowing costs rise.
The point is that buying the entire S&P 600 simply because it is cheap is proving fruitless. A better way to take advantage of attractive valuations is to pick a basket of individual names that have shown particularly strong earnings trends, but that are also inexpensive.
"Small/Mid Cap is an increasingly attractive opportunity set for stock selection," writes Citi strategist Scott Chronert. "Valuations are compelling."
Chronert screened for small and mid-cap stocks -- generally those valued at less than $20 billion -- that Citi analysts rate at Buy, forecasting total returns of at least 10%. That captures companies the analysts consider inexpensive and well positioned for higher profits.
A few examples are Texas Roadhouse, a restaurant operator with a market cap of $12 billion; the lender Ally Financial, at $10 billion; the transport company XPO, at $14 billion; and Eagle Materials, a $9 billion building-materials company.
Barron's further narrowed the focus, looking for companies where analysts' forecasts for earnings have remained stable or risen since the start of the year, even as aggregate profit forecasts for the S&P 600 have declined. We only picked companies trading at no more than 15 times forward earnings, the aggregate figure for the index. That is far below the S&P 500's nearly 22 times.
One is the $11 billion insurer Unum Group. Earnings estimates have risen by 9% this year. The stock trades at seven times earnings.
A more appealing example is Abercrombie & Fitch, with a market cap of $7 billion. It trades at 12 times expected earnings for the coming 12 months. Since the start of the year, analysts' expectations for 2024 sales have risen a few hundred million dollars to $4.8 billion, while forecasts for same-store sales growth have risen to 13% from less than 6% in January.
Abercrombie turned in higher earnings than expected in the second quarter. It has won market share in retail, selling more items even with higher prices for its major brands worldwide.
Analysts' consensus forecast for 2024 earnings has risen almost 75% this year as expectations for profit margins have improved. And Wall Street expects continued earnings growth for the next few years as the small brand takes advantage of its prices and higher gross margins to gain market share by spending more on marketing.
These names offer the potential for better returns than buying the entire group of small-caps.
Write to Jacob Sonenshine at jacob.sonenshine@barrons.com
This content was created by Barron's, which is operated by Dow Jones & Co. Barron's is published independently from Dow Jones Newswires and The Wall Street Journal.
(END) Dow Jones Newswires
October 30, 2024 03:00 ET (07:00 GMT)
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