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Small-Cap Undervaluation Suggests a Turnaround Is Due


After three straight down month for small-caps, could this be the start of something big?

As of Friday, October 27, 2023, small-cap stocks were heading for a third consecutive down month. Both the Russell 2000 and the S&P SmallCap 600 indexes have been tracking far behind large-caps since early March when small-caps gave up their strong start out of the gate in early 2023.

In October 2023, the Russell 2000 is set to record a third straight monthly decline of at least 5%, which, according to Dow Jones Market Data, has not happened since the three months ended November 2008.

At Friday's close, the S&P SmallCap 600 has given up nearly three years of gains, retreating to levels last seen in November 2020 when the markets experienced a pandemic-fueled uplift.

In mid-October, small-cap stocks had reached decidedly cheap levels of valuation relative to larger stocks. At the time the average P/E ratio of both the Russell 2000 and the S&P SmallCap 600 indexes was less than 13. Compare that to the S&P 500 P/E ratio of 21 and the tech-heavy Nasdaq 100 P/E of 29, and it is apparent that there are values to be uncovered in small company stocks.

It is not hard to understand the cause of small company jitters. Investors are gun-shy about the risk of recession and the impact of higher interest rates on small companies, both of which affect small companies more severely than large companies. Small companies in need of capital will likely continue to  pay more for borrowing than large, established businesses, and this premium can be considerable.
And while I am on record as preaching that the risk of recession continues to be even more remote as the present sideways cycle continues, many investors find it hard to ignore the pervasive fear-mongering headlines that raise the specter of a massive economic downturn. (News flash: Despite the Fed's efforts to slow the economy by maintaining high interest rates, strong consumer spending in the third quarter drove the US economy a robust 4.9% from July through September. This is exactly the opposite of a recession.)

This ongoing strength in the U.S. economy makes a small-cap turnaround much more likely. However, the bull case for a small company upturn hinges on the perception that the economy is strong, along with investors finally coming around to the fact that economic indicators do indeed show progress being made.

Investor reticence means that a  focus on individual stock selection is even more important, but the benefit will be substantial once the quantifiable absolute strengths of the economy convince the bears that the downside risks are limited, and the stocks of well-run small businesses will finally turn in performances for which investors have been waiting. But do not wait too long—being late to this party may mean that you will miss out on the largest gains that the recovery will bring.

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In this issue of the SmallCap Informer we revisit a company previously covered in the newsletter that has recently been dealt a bad hand, but the price decline is likely to only be temporary. In our analysis, the odds look good for the company’s future.   

Stay the course!


Subscribers can read Doug's complete commentary and in-depth profile of our recommended small company stock in the November 2023 issue of the SmallCap Informer stock newsletter. Not a subscriber? Subscribe to the SmallCap Informer and get monthly small company stock recommendations and updated buy/sell prices for each of the 49 high-quality small company stocks currently covered in the newsletter.