Small Market Cap Stocks Offer Big Value

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The Case for Small Cap Value Stocks:

• The chart below shows that Small Cap Value is as cheap vs. Large Cap Value as any time in history
• We have been drawing peoples’ attention to the growing opportunity in charts and white papers on quality spreads in mid cap and small cap companies
• As demonstrated in nearly a dozen of our quick takes and white papers, the euphoric mania for growth stocks has left pockets of fantastic opportunities for disciplined active managers willing to buy quality at reasonable prices

Since the trough of the Covid crash on March 23, 2020, Small Cap Value stocks have risen 128.44% vs Large Cap Value stocks rising “only” 93.21%. This has led some to worry that Small Cap Value has run too far. The KCR team notes that since 2017 however, Large Cap Value has beaten Small Cap Value by nearly 2% annually (+59.49% vs. +46.21%).

The table below shows the basic fundamentals of the following three groups:

1. The first row is the Russell 1000 Value Index
2. The second row is the Russell 2000 Value Index
3. The third row shows our top 10 ranked Small & Midcap stocks in the Russell 2000 Value Index

KCR thinks the appeal of moving down the groups is reasonably obvious. The major complaint we could see coming from a cursory observation of the indexes are the elevated PE ratios and the lower ROAs of the small caps. We do not profess to be experts in Large Value vs. Small Value (yet!) but a cursory examination of the two benchmarks is informative.

The R2V has a 12% weighting in REITs, nearly triple that of the R1V, and the sector’s earnings are still reeling from the pandemic. Needless to say, a vast array of stocks that have negative PE ratios in the R2V REIT sector does not flatter the overall index valuation^[1]. Looking at FCF/EV however we get a better sense of the opportunity in the R2V. Overall, many of the loss making firms in the R2V have not actually translated to negative cash flows.

We ask our readers to focus on the last row in the exhibit: our top 10 ranked names in the Russell 2000 Value index.

Suffice it to say: the opportunities strike us as substantial. With an 8.6% FCF yield and valued at only 0.4x sales, our top ranked firms appear priced for disaster. Many of our top ranked names have only one or two analysts, are involved in logistics, transportation, housing and automotive sectors – and some have global brand recognition!

In a world where the Russell 1000 Growth Index has a 44% weighting in tech names trading at stratospheric valuations, we think there might be much to endorse these small businesses that engage in the prosaic. The KCR research team has no idea if Square can grow into its $120 billion market cap and 730x PE ratio.

We do however think some of our top ranked small cap value names will be shipping goods and selling tires for many years to come. For an example of a possibly mispriced small cap stock please see our free write-up on MHK’s stock price – this is a company that is a great example of how we think about the opportunities that exist today in a quantamental framework.

Login or subscribe below to see the list of potential stocks to buy after some diligent fundamental research. You can also click here for our Small Cap ranking tool. For growth investors, we continue to advocate for the lost are of “growth at a reasonable price” as we believe the opportunities there are the best we have seen in our lifetimes!