5 game changers for small-cap stocks
These signs of U.S. economic recovery support more investment risk
Reuters
CHICAGO (MarketWatch) — This spotty economic recovery has fooled more than a few: bad days for bears, good days for champions of small-cap stocks, whose strong rebound just may continue.
In that constant churn between “risk on” and “risk off,” investors have been getting a little more adventurous, and small caps are delivering. The Russell 2000 Index (RSU:RUT) rose 7% last month, marking its best January since 2006. The Fed’s pledge of low interest rates certainly helps small-capitalization firms, which often have more trouble borrowing than their bigger rivals.
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Most economists think the U.S. economy will chug along, with several looking for 2012 GDP growth of around 2% or a little better. That’s not bad for a base case, considering global pressures and timid executives and consumers still smarting from the financial crisis and recession.
The small-cap story is playing out in earnings results. Four of every 10 small-cap companies are beating Wall Street expectations so far this year, and 54% have topped the sales estimate in recent reporting rounds, according to Bank of America Merrill Lynch.
But have small-cap stocks come too far, too fast?
“We are sticking with our [small-cap] return target of 11.5% for 2012 despite the strong gains to start the year, as the U.S. economy is expected to slow in the back half of the year but earnings expectations do not reflect this trend,” said Steven DeSanctis, head of U.S. small-cap strategy at B. of A. Merrill in a recent research report.
“Volatility will rise thanks to Europe, the U.S. presidential election, new fiscal policies, and the Middle East,” he added. “This could put a damper on performance going forward.”
Yet Jeffrey Schwartz, senior portfolio manager of the Pyxis Small-Cap Equity Fund (MFD:HSZAX) , argued that the small caps is precisely where to position a portfolio for domestic economic growth because the space has less exposure to troubled international areas than both midcaps and large caps.
Clearly there may be a few snags to the small-cap thread. That said, with the required caution also considered, here’s a short list of economic catalysts and market sectors where improved conditions should bode well for small-cap stocks:
1. Banking and credit
There’s so much bad news priced into financial shares, “it sure wouldn’t take much to reignite fundamental improvement,” said Lawrence Creatura, manager of the Federated Clover Small Value Fund (MFD:VSFAX) . “Expectations are subterranean. Nobody expects the environment to get much better here soon.”
With pessimism about the economy still prevalent, Creatura is looking closely at smaller banks with a regional focus.
“Pick your region, your management team, the type of lending you prefer, and track lending history,” Creatura said. “Small-cap financials have a huge advantage in this environment to the conglomerate banks.”
For example, his fund includes Ocwen Financial Corp. (NYSE:OCN) .
Still, banks have little interest-rate margin, no matter their size. Foreclosure backlogs are still unclogging. And Europe remains a risk to financial-system health, though more safeguards may be in place since 2008.
2. Home builders
The trend is up in both housing construction and resale data. Starts jumped more than 9% in November and promptly fell a deeper-than-expected 4% in December. Industry surveys of residential builders are more optimistic. In late January, California-based builder Ryland Group Inc. (NYSE:RYL) reported a narrow profit after seven straight losing quarters. Its stock has doubled since October’s low. That should provide some inspiration for careful bargain hunting in the space, particularly those names yet unnoticed, according to analysts. Read more: Hope for home builders is bright, but for how long?
That said, “For Sale” signs still dot many a cul-de-sac. Borrowing conditions are more favorable, but credit access and efficiency have been slowly catching up. Read more: Mortgage delinquencies, foreclosures decline.
3. Business investment
In this case, technology investment is the key driver. Balance sheets are much improved and companies will have greater leverage as the economy gets better. Creatura said cloud computing and social networking are primary beneficiaries of business investment.
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“Companies have to reinvest in tech and infrastructure to keep up with the way the customer is researching and purchasing,” he said. He added that the recession weeded out tech firms that didn’t adapt, and those left standing are positioned to ride the economic upswing.
Software multiples are at three times enterprise value/sales compared with one times EV/sales for hardware. The divergence shows the investment community believes hardware capital expenditures will climb, said Satya Pradhuman, director of research at Cirrus Research LLC.
The semiconductor sector’s book-to-bill ratio looks to have bottomed at 0.71 and has risen in its last three monthly readings, standing now at 0.88. Yet valuations for semiconductor stocks, Pradhuman said, are at levels last seen late in 2004.
Semiconductor makers “may be the poster child for high beta in this current market environment,” he added. “Mid- and small-cap semis have recovered a good portion of their 2011 loss but still have room to run.”
Stocks his firm rates “most attractive” include Vishay Intertechnology Inc. (NYSE:VSH) , Veeco Instruments Inc. (NASDAQ:VECO) and Amkor Technology Inc. (NASDAQ:AMKR) . Also on the list: Entegris Inc. (NASDAQ:ENTG) and RF Micro Devices Inc.(NASDAQ:RFMD) . Read more: 5 money moves a small-cap stock pro is making now.
4. Retail sales and consumer discretionary spending
For consumer-discretionary stocks, those focused on retailers in particular, it’s survival of the fittest. Nowadays, small-cap investors can pick from the premium crop, Federated’s Creatura said. During the recession, retailers worked down inventory and built up technology that better allows them to control in-demand inventory, plus spot and stock trends (including sizing) more efficiently.
Consumer-sentiment gauges improved late in 2011 but paused to start the year. The trend here has been up. “Consumers are more upbeat about employment, but less optimistic about business conditions and their income prospects,” said Lynn Franco, director of the Conference Board Consumer Research Center. Still, any sign of an economic stall, and investors are likely to scamper back into defensive consumer-staple stocks.
5. Hiring strength
The best reading for job growth in nine months in January has some strong supporting data. The four-week moving average of jobless-benefits claims is near a four-year low. Some companies are lean to the point of skeletal, and, while many may get by with fewer workers, others need help to handle new orders.
According to the Conference Board, consumers’ outlook for the labor market is moderately more favorable. Those expecting more jobs in the months ahead increased to 16.2% from 14%, while those anticipating fewer jobs has declined to 19.5% from 20.2%.
Who’s hiring? According to Indeed.com, an employment website, health-care postings are up 42% on a year-over-year basis; hospitality listings are up 36%; manufacturing, up 22%; and construction-related jobs up 15%.
By Rachel Koning Beals
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