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Small-Cap Stocks Are Currently Residing in a Great Neighborhood

10/2/2022

The market's latest tumble puts small company stock valuations at a very attractive level.

It is worth repeating that no one can predict the top or bottom of any stock market with any degree of accuracy, and our approach to selecting and investing in individual stocks does not require knowing whether a stock or the market is at an absolute peak or trough.

Still, many investors spend precious brain capital vainly attempting to work out when to get in or get out of the market at precisely the “right” time.

For those who are worried, it can be useful to think of the broad equity market as being in regular transit between two bordering neighborhoods: call them Bulltown (where stocks tend to be fairly- or over-valued) and Bearsville (where stock spend their days largely under-valued). Fortunately, stocks tend to hang out in Bearsville for just 12 to 19 months before heading back across town to Bulltown where they will take up long-term residence for several years.

There are no guarantees about how long stocks will reside in their current neighborhood, but there are other road signs that indicate that this may be a good time to pack up and prepare to get the heck out of Bearsville.

I reiterate my view first expressed in mid-summer that the markets and economy may have already seen their worst, and that improvement may come sooner than many expect. I make this observation with the caveat that there is always a chance that the markets and U.S. economy will well get worse before they improve.

This position will be received with skepticism by some, but my rationale is based on the magnitude of the market’s decline (quite large) coupled with the forward earnings expectations of many companies (much reduced) and resulting valuations (very discounted) that have been assigned to equities by analysts and investors.

In other words, stocks were (and are) cheap by historical standards, valued with are likely to be overblown fears about economic collapse, higher interest rates, and equities falling out of favor. In a climate of fear, even the slightest gust of wind or trickle of rain can send investors running for cover.

But when you review the most salient business outlook data and valuations of many stocks, it is not hard to reach the conclusion that any further downside to the broader market is not likely to be significant compared to the decline that the broader market had already seen from January to June.

In other words, after stocks saw a bear market decline of more than 20% in the first half of 2022, any further weakening of stocks would likely not be as severe as the market had already thrown at investors. The bulk of the damage was already done.

The subsequent market rally of July and August may have lured investors out of Bearsville, but not for long. By the end of September, the S&P 500 was back in the bears’ neighborhood just slightly deeper than the last bottom in June. Things were a little worse than the worst the markets had seen three months before, adding just 2% or 3% to the 20% the markets had already survived.

While I do not go so far as to suggest that a return trip to Bulltown is imminently forthcoming, I think it is still very likely that the Bearsville neighborhood in which stocks are currently living is most assuredly providing plenty of interesting investment candidates. One key advantage of investing with a long-term horizon is that five or ten years down the road, it won’t matter whether an investor was a month or two or three early or late to the party.

Which begs the question: are we in the right neighborhood to start thinking about buying stocks with vigor?

Looking at small-cap stocks in particular, Ed Yardeni of Yardeni Research points out that the forward P/E ratio of the S&P SmallCap 600 Index was 10.8 as of September 23, 2022.

Considering that analyst pessimism about small-cap earnings in the next twelve months are built into this P/E, investors are still shying away from small-caps.

But in the last 23 years, small-cap stocks have only been in this neighborhood twice before: in 2020 when the pandemic arrived, and in 2008 during bear market caused by the financial/housing market crisis.

And since 1999, there have been only seven other times when the S&P SmallCap 600 forward P/E fell below 14.0.

In all the above cases, when the S&P SmallCap 600 P/E reached these levels, recovery was not far off. Small stocks did not hang out the neighborhood for very long at all.

Will that be the case now? Time will tell, but identifying individual companies that have strong business outlooks and much-reduced valuations will certainly prove profitable over the long-term.

For other companies, it’s true that economic uncertainty is causing investors to hold off on buying stocks in many industries that we cover in the SmallCap Informer, such as residential construction, building supplies, and RV companies. Their stocks dominate our coverage list when ranked by highest long-term total return and lowest P/E ratios, but it wouldn’t be wise to buy any of these companies in search of quick returns.

On the other hand, accumulating some of these holdings and putting them into deep storage could be a very wise move. Our current top selections include an IT services provider that primarily works with Federal agencies and departments. This should provide a good measure of ongoing business vitality in a recessionary environment as government contracts do not ebb and flow along with the economy.

The other pick in the October 2022 issue of the SmallCap Informer is a business services company with a focus on digital transformation. The stock has been on our watchlist for some time, but its recent pullback puts it in interesting valuation territory.

Stay the course!

  • DOUGLAS GERLACH

Read the complete commentary and profiles of our two recommended small company stocks in the October 2022 issue of the SmallCap Informer stock newsletter.

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