3 Small Caps With Big Profit Potential

Stocks of the largest companies boomed last year with the S&P 500 posting a 19% return versus just 12.5% for small cap peers in the Russell 2000 Index.

The phenomenon surprised most analysts as shares of smaller companies generally outperform during periods of economic growth and low volatility.

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Small cap stocks are reasserting their leadership though, and data points to a very good outlook for companies in the Russell 2000. The index of companies with market cap under $5 billion has climbed 10.7% so far in 2018 versus just 6.5% for their large cap peers.

#-ad_banner-#Three tailwinds should support that outperformance for the foreseeable future and drive profits in the small cap universe.

Small Cap Companies Benefit From Economic And Geopolitical Tailwinds
Last year’s outperformance by large cap stocks may not have been all it appeared. Earnings growth was boosted by stock buybacks rather than sales growth and just a handful of massive companies drove the majority of index gains.

Apple, Alphabet, Amazon and Facebook alone make up nearly 10% of the S&P 500 by weight and averaged a 49% return, dragging the rest of the index higher.

By comparison, tailwinds to the universe of small cap stocks is broad based and could mean the group continues to shoot higher this year and into 2019.

Smaller companies with predominantly U.S.-based supply chains and domestic sales face less risk in an escalating trade war. The public comment period has ended on a proposed tariff of 25% on up to $200 billion of Chinese imports and President Trump could announce the new restrictions any day.

The U.S. and China have already gone tit-for-tat with tariffs on $50 billion in goods and China has vowed to retaliate against any new measures. While a trade deal with Mexico looks to be inked by year-end, tensions are still running high with Canada and the European Union.

Companies in the S&P 500 book 44% of their sales overseas, according to data from FactSet Research. Not only do they depend heavily on foreign sales, but supply chains are also heavily reliant on smooth trade. Companies in the Russell 2000 index, however, book just 20% of total sales overseas.

Companies in the small cap index are also likely to see greater benefits from the change in U.S. tax rates. These companies were not benefiting from lower rates overseas because of their predominant U.S. sales so were generally paying a higher effective tax rate.

Companies in the small cap index paid a median effective rate of 31.9% before the change in rates, according to Thomson Reuters data. That’s at least 14% higher than the average rate of 28% reported by companies in the S&P 500.

Finally, that relative dependence on U.S. business at small cap companies versus their international peers is proving to be a tailwind in the country’s economic outperformance.

The U.S. has been the clear economic standout during this bull market with Europe and Japan still clinging to monetary stimulus for growth. Emerging markets have recently plunged into a new currency crisis and China’s growth is looking vulnerable to an escalating trade war.

Domestic growth touched a multi-year high in the second quarter at 4.1% and an increase in capital spending as high as 7% could help U.S. GDP climb by 3% or more on the year, according to the Conference Board.

The bears will say that small cap stocks will be more volatile in a market correction but if this market has taught us anything, it’s that calling an inevitable crash has been a fool’s errand. Inflation is moderate at best, corporate profits are expected 22% higher for the year and the monthly employment report continues to beat estimates.

There may be nothing left to stop small caps from their resurgence.

Three Small Cap Companies With Solid Catalysts For Growth
Of course, that outperformance in shares of small cap companies won’t be uniform. Small caps are known for their volatility and some companies will be failing as others reach new highs. Finding the best-of-breed companies means using fundamental analysis and looking for catalysts for growth.

Synaptics (Nasdaq: SYNA) is a $1.6 billion semiconductor firm specializing in advanced touch display controllers (OLED) and primed for growth in the consumer internet of things (IoT). The company has used a strategy of internal development and acquisitions to position broadly across mobile, PC and consumer tech.

Management is making the tough decision to restructure its optical fingerprint business to clear the way to a refocus on OLED and IoT. The move should help the company improve profitability as it develops its stronger products.

The company has a healthy balance sheet with $301 million in cash and is producing over $100 million in free cash flow a year. Shares trade for just 11.3 times trailing earnings, which are expected 13% higher over the next four quarters to $4.61 per share.

Sensient Technologies (NYSE: SXT) is a $3 billion developer of colors, flavors, and fragrances for the consumer goods market. The company develops proprietary inputs for its customers in consumer goods manufacturing that provide a certain taste, color, or smell to the product.

This means Sensient enjoys a strong loyalty among customers because a change of supplier could materially alter what end-users have come to expect in terms of taste and smell. That stability combined with a competitive advantage in its patents has helped the company post operating profits in every business segment for every quarter of the last decade, including during the global financial crisis.

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Sensient recently completed a major three-year restructuring through 2017 that should lead to drive profitability. Only two analysts cover the share, so improved fundamentals could catch the market by surprise. Shares trade for 20 times trailing earnings which are expected to increase 7.7% to $3.92 per share through 2019.

Legg Mason (NYSE: LM) is a $2.6 billion asset manager, primarily servicing institutional clients. Lower fees on index funds have pressured asset managers though the company’s higher percentage of assets from large money manager clients help to shield it from some of the price competition.

Despite fund outflows in the company’s equity assets under management (AUM), money continues to come in on the fixed-income side and the firm’s $744 billion in total AUM gives it the scale to be competitive on fees.

Management’s decision to focus on reducing financial leverage over the next year will probably mean no share repurchases but will dramatically improve its balance sheet. This could improve investor sentiment and drive the share price higher. The shares trade for just 7.7 times trailing earnings and pay a 4.4% dividend yield to investors willing to wait for the turnaround.

Risks To Consider: Small caps will be relatively volatile around any market correction though the longer trend continues to point higher.

Action To Take: Take advantage of macro tailwinds to position in the resurgent small caps as they outperform this year and next.

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