Small-cap stocks have been a reliable way for investors to outperform the S&P 500 for a long time. In the last 17 years the iShares Core S&P Small Cap (NYSE: IJR) has gained 335%. That's more than a 300% premium to the 74% return of the SPDR S&P 500 ETF (NYSE: SPY) over the same period. This huge discrepancy is shown below.
However, over the last three years this performance gap has evaporated. With investors fearful of another big stock market crash and huge waves of retirees piling into dividend stocks in search of yield, small-caps have temporarily fallen out of favor.
As you can see in the chart below, small caps have only fared slightly better than the S&P 500 over the last three years. Take a look below.
In the short run, this has been frustrating for small cap investors. They took the risk of higher volatility without the reward of outsized returns.
However, it has also created a rare value opportunity. Right now there are an abnormal number of small cap stocks that are trading with historically low valuations while still offering huge growth potential.
I put together a screen of the Russell 2000, a leading index of 2000 small cap stocks, to showcase these opportunities.
The S&P 500 currently has a forward P/E of 19 and is expected to grow earnings by around 10% in 2017. From my screen, I have identified seven small caps with the best combination of value and growth. They offer better growth potential than the S&P 500 while also trading with a lower P/E ratio. Take a look.
|Name||Ticker||Forward PE||2017 EPS Growth Est.|
|Carizzo Oil & Gas||CRZO||16.2||12.9%|
From this group, I have chosen to highlight Firstbancorp and KB Home because they offer the best combination of growth and value.
First Bancorp (Nasdaq: FBNC) is a great way to cash in on rising interest and ongoing deregulation in the financial sector.
However, because of its smaller size, First Bancorp offers potential earnings growth that the big banks can only dream of. While JPMorgan is projected to grow earnings by 7.9% in 2017, Bancorp is projected to grow earnings by 34.6%, more than a 300% premium to JPM. The earnings bonanza is expected to continue in 2018, with earnings projected to grow another 18.9%.
Despite that bullish earnings growth projection, Bancorp still offers major value. Its forward P/E ratio of 17.3 is a discount to the S&P 500's 18.9 and its own 5-year average of 48.6.
KB Home (NYSE: KBH) is one of the largest residential home builders in the United States. But with a market cap of $1.9 billion, this industry leader still qualifies as a small-cap.
KB has been cashing in on the ongoing recovery in the U.S. housing market. In the last four quarters KB has beaten earnings estimates by an average of 7.3%. Moving forward, that earnings momentum is expected to continue. Earnings are expected to grow 43.3% in 2017 and another 22.8% in 2018.
Despite the bullish growth projections, this is another undervalued small cap. KB's forward P/E ratio of 13.3 is a 28% discount to the S&P 500 and its 5-year average of 18.4.
Risks To Consider: Small caps are going to be more volatile on the chart than their large-cap counterparts. If you invest in small-caps, you have to take the long-term view and be willing to ride out smaller price fluctuations.
Action To Take: First Bancorp and KB are two of the most undervalued small-caps relative to their earnings growth potential. Buy both right now and look for strong earnings growth in the next two years to drive shares to new highs.
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