As high inflation makes the Fed more hawkish and recession fears rise, many advisors are focusing on the S&P 500 with characteristic large-cap tunnel vision.
Amid all this, there’s been little notice of a market dislocation that has developed over the past 12 or 13 months: Despite much stronger earnings, S&P small caps have underperformed large caps by nearly 13% (2.1% to 14.9%).
For advisors convinced that a recession will begin this year or early next, a lack of attention to this dislocation might be a strategic misstep.
Though many assessments of the economy, pointing to current brisk growth, don’t suggest a recession before 2024 (if even then), many advisors persist in drinking the recession-is-near Kool-Aid. They obsess over the two-year/10-year Treasury curve as if it were a Delphic oracle, but this is the wrong curve. The more predictive one is the three-month/10 year, which is currently steepening. And regardless, recession forecasting should involve other factors.
Yet, especially for those with recessionoia, this would be a natural time to focus on small caps.
Strong Exit
That’s because small caps are generally more resilient against recession than large. One reason for this is that they often enter recessions already beaten up. And relative to large caps, they’re beaten up now. The Russell 2000 was down 23% from its 2021 peak through April, while the S&P 500 was down about 13%.
Small cap performance when exiting recessions is another matter. They’ve bested large caps coming out of nine of the last 10 recessions, with outperformance beginning roughly at the midpoint and continuing for about a year after recessions end.
Also, small caps have historically outperformed large over some extremely long periods and, notably, it’s been years since they’ve done so. From February of 2000 through mid-April, IWM was up 313% compared to SPY’s 205%. However over the last five years, large caps have outperformed small two to one. This history, along with the current dislocation, might be the basis for a strategy to buy small caps now, regardless of where you stand in the recession fear spectrum.
Generally, it’s hard for long-term investors to go wrong by buying well-chosen, beaten-up stocks with low-risk characteristics. And the equity risk premium for small cap value stocks is currently double that of large caps. As of early March, Vanguard’s S&P 500 fund had an earnings yield of 5.07%. Measured against a 10-year Treasury rate of 2.72%, this makes the fund’s equity risk premium 235 BPS. At the same time, the equity risk premium of Vanguard’s small cap value fund was 570 BPS—from applying the same math to its much lower P/E, 11.9. Five hundred BPS, of course, reflects miniscule historical risk.
Good Opportunities
Some good current opportunities in small cap stocks lie in a range of sectors. The most attractive of these stocks have a P/E less than or equal to their earnings growth (that is, a PEG Ratio of 1.0 or less), have posted an upside surprise in their last earnings announcement, and pay a dividend.
Here are six examples of stocks with these characteristics, along with low downside risk profiles (according to various other fundamental, technical, and sentiment measures):
• Avnet (AVT). This Phoenix-based maker of electronic components has a P/E of only 8, but projected five-year average annual growth of 16%—essentially, growth that’s double the current price. The company beat earnings estimates by almost 19% in the most recent quarter. Further, in the last 90 days, analysts’ earnings estimates for 2022 have increased 15% and for 2023, 17%. Avnet’s current stock price is about the same as it was five years ago, but over that period, EPS has gone from -$2 per share to about $5. Sales have been fairly flat, rising only 12% total over five years. As a result, analysts seem to have a show-me attitude regarding Avnet. But by the time sales improve, currently strong fundamentals might have driven the price much higher. The dividend yield is quite high at about 2.7%.
• Rush Enterprises (RUSHA). This national retailer of commercial vehicles (mainly trucks), based in New Braunfels, Texas, has a P/E of 11, yet earnings have grown more than 15% over the past year. For the most recent quarter, the company posted an upside EPS surprise of 20%. According to Yahoo Finance, over the last 90 days, earnings estimates have increased 9% for this year and for 2023, 10%. The stock price in late April was about $48, roughly where it was a year ago, and the average one-year target is $66, or 37% higher. The dividend yield was about 1.6%.
• ACCO Brands (ACCO), a suburban Chicago manufacturer of office and school supplies. The P/E is 7, and its projected annual growth is 9%. The most recent quarter surprised on the upside by 20%. The dividend yield is high at nearly 4%, and the earnings trend is good. Over the last 90 days, earnings estimates for 2022 have edged upward. The stock price was only $7.42 in late April. Five years ago, it was $11, but the current average one-year target is $14.
• Griffon (GFF). This New York City-headquartered multinational conglomerate for building products and defense electronics has P/E of 15 and a growth rate of 17%. The recent quarter surprised on the upside by more than 200%. In the last 90 days, earnings estimates for this year have increased about 15% and for 2023, about 16%. As of late April, it was trading at about $18, lower than it was five years ago and down 28% over the last six months. But the average one-year target is $36, or 100% higher. The dividend yield is about 2%.
• Quanex (NX), a Houston-based manufacturer of building products. Quanex’s P/E is 11, with an earnings growth rate of 12%. The most recent quarter surprised on the upside by more than 32%. The dividend yield is 1.6%, and the earnings trend is good: In the last 90 days, estimates for this year have been raised 9% and for 2023, 10%. In late April, stock was trading at $21, lower than it was five years ago, and down more than 5% over the last six months. The average one-year target is $32—52% higher than the current price.
• Greif (GEF), a Delaware, Ohio-based maker of packaging products. The P/E is 7.5, and so is the earnings growth rate. The most recent quarter surprised on the upside by more than 7%. Greif’s dividend is huge at 4.6%, with a good earnings trend. Over the last 90 days, earnings estimates for this year have been raised 7% and for next year, 8%. In late April, the stock was trading at about $60—down by more than 11% over the past six months. The average one-year target is $68.
Deglobalization
The nascent deglobalization trend, a reaction to worldwide supply chain disruption and increasing global political risk, could benefit small companies significantly. With large companies siting more manufacturing on American soil (e.g., Intel’s new plant in Ohio), they’ll probably be developing increasingly domestic supply chains, creating more business for more small companies.
If this trend continues, it could move the revenue needle for some small caps.
Dave Sheaff Gilreath, CFP, is a founding principal and CIO of Innovative Portfolios, an institutional money management firm, and of Sheaff Brock Investment Advisors. Based in Indianapolis, the firms manage about $1.4 billion.