Inflection Point for Small-Cap Stocks

This article was written with Oliver Pursche, the Co-Portfolio Manager of the GMG Defensive Beta Fund. It was part of a series of articles developed under an agreement with to work with a variety of contributors and assist them in delivering actionable investment ideas each week.

Although the bull market appears to be healthy and ready to march on, there are some indications that a shift in market leadership is getting closer.

As the S&P 500 and Dow Jones Industrial Average continue to make new highs, I am noticing a new trend within the components of these averages — sellers are coming back.

As a result of sifting through various fillings by hedge fund managers, reviewing daily market buy/sell volume and overall market breadth, I see a shift in leadership occurring: small-cap value stocks are beginning to emerge.

Don’t get me wrong, I’m not suggesting that large multinationals will come crashing down or represent poor investments. I am, however, suggesting that their small-cap brethren are likely to begin outperforming these global behemoths.

One fact that raised my suspicions was momentum in small-cap revenues and earnings vs. larger companies.

Specifically, while the Russell 2000 Small-Cap Value index has posted similar returns to the S&P 500, the valuations are quite different. Whereas revenues for constituents of the S&P have grown by a little less than 5% over the past 12 months, revenues for the companies within the Russell 2000 Value are up 9.7% year over year.

More importantly the growth in net margins for small caps is 11.2% vs. 9.6% for the S&P 500. Net, net then, I believe that prevailing large cap price-to-earnings ratios do not reflect what I see as unsustainable margin improvements. As we see this play out over time, small-cap stocks and indices are positioned to rise at the expense of large-caps, which appear destined to fall as new margin improvement prove difficult to find.

Small-cap stocks have the reputation of being riskier, young companies whose stock is more volatile than the broader market. This reputation is warranted, and one reason why stock picking among small-caps, rather than making a broad sector bet, can deliver alpha.

With this in mind, here are some of our favorite names, which are included in our small-cap separate accounts strategy: Cheese Cake Factory (CAKE), Lancaster Colony (LANC), Owens & Minor (OMI) and Wolverine World Wide (WWW).

Portfolios focusing on low-volatility, high-quality small-cap stocks may be able to reduce overall portfolio volatility and achieve better returns. Growth-oriented investors should start rotating into small-caps, as they could come back into favor soon.

At the time of publication, the following stocks may be owned in the GMG Defensive Beta Fund and/or Gary Goldberg Financial Services and in separate accounts: CAKE, LANC, OMI and WWW. Pursche is co-manager of the GMG Defensive Beta Fund and is president of GGFS.

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