By Philip van Doorn
You might be surprised to hear that small-cap stocks are trading inexpensively compared with their larger peers. Indeed, they are — if the data are confined to profitable companies.
And small caps are expected to grow their earnings more quickly than larger companies. So this may be an excellent buying point for long-term investors.
Small-cap stocks, as represented by the S&P Small Cap 600 Index /zigman2/quotes/210599868/delayed SML -0.38% , have outperformed large-cap stocks this year:
In an interview, Timothy Skiendzielewski, co-manager of abrdn’s $2.6 billion U.S. Small Cap Equity Strategy, discussed six smaller companies that he argues are set up for long-term growth. They are listed below.
Skiendzielewski, who is based in Philadelphia, manages the $1.1 billion Aberdeen U.S. Small Cap Equity Fund. The fund’s Institutional share class /zigman2/quotes/204051293/realtime GSCIX -0.86% is rated four stars (of five) by Morningstar, while Class A shares /zigman2/quotes/205642226/realtime GSXAX -0.84% have a three-star rating.
Abrdn is the new name of Standard Life Aberdeen, which is based in Edinburgh, Scotland.
Smaller companies with big profit growth
The strategy’s benchmark is the Russell 2000 Index /zigman2/quotes/210598147/delayed RUT -0.78% . The forward price-to-earnings ratio for the iShares Russell 2000 ETF /zigman2/quotes/209961116/composite IWM -0.67% is 25.7, compared with 20.4 for the large-cap S&P 500 Index /zigman2/quotes/210599714/realtime SPX -1.04% , based on weighted aggregate earnings estimates for the next 12 months, among analysts polled by FactSet. So, by these measures, the small-cap Russell 2000 seems more pricey.
But the Russell 2000 includes many early-stage companies that aren’t expected to show profits over the next 12 months. The S&P Small Cap 600 Index trades lower because most of its companies are profitable. Standard & Poor’s criteria for initial inclusion in the index includes positive earnings for the most recent quarter and for the sum of the most recent four quarters. So it is a far more selective list than the Russell 2000, and its forward P/E is 15.4 — much lower than that of the S&P 500.
And the small-cap group is expected to increase earnings more quickly than the large caps. Stripping out unprofitable companies from the Russell 2000 index, Jefferies analyst Steven DeSanctis estimates small-cap companies will increase their 2021 earnings by 42% from their pre-COVID 2019 levels, while the S&P 500, on the same basis, will increase earnings by 26%.
Skiendzielewski sees “a relatively large discount” for small-cap stocks, which “have typically traded anywhere from an 8% to 10% premium to large caps.”
Zeroing in on six small-cap stocks
Skiendzielewski says investors are worrying too much about small caps, in light of the resurgence of coronavirus infections. Even as winter approaches, he doesn’t expect an economic shutdown on a scale similar to the one that took place during the first half of 2020.
He also sees the current environment as one that is especially good for active managers seeking overlooked long-term plays among small-cap stocks, which may only be covered by few Wall Street analysts.
Here are the six stocks he mentioned during the interview.
Health Catalyst Inc. /zigman2/quotes/213268802/composite HCAT -1.42% develops software used by hospitals. “They essentially allow hospitals to dig into the data that comes in from all systems and make decisions” on how to source materials and manage staff and hospital populations, Skiendzielewski said.