The Russell 2000 U.S. small-cap index recently broke above its early September peak and now sits only roughly 5% from January 2020, pre-COVID highs.
Small-cap growth stocks, which have led the small-cap rally since March, have already broken out to new highs (see the Russell 2000 Growth index chart). This leadership has been driven by strong performance from health care and technology stocks, which make up approximately half the index. Breadth has been strong, as more than 70% of small-cap growth stocks are currently trading above their 50-day moving average, whereas more than half the stocks in the Russell 2000 Value index are still down for the year.
Several factors may be at work here: first, the significant performance and valuation gap between small and large U.S. stocks (most notably large growth) over the last several years (see chart below) combined with investor optimism that the U.S. economy will improve in 2021.
In addition, small caps are inexpensive from a historical perspective relative to large caps, shown in the chart below from Furey Research Partners in Newport Beach, California. As institutional small-cap strategist James Furey notes, small-cap relative valuation is up off recent lows and roughly in line with 2000‒2001 lows, which preceded a strong small-cap relative P/E expansion and improved performance as the market recovered from the recession that followed the bursting of the dot-com bubble.
With this in mind, investors should consider adding strong small-cap stocks to their portfolios if they have not already. Here are five small caps that I think screen positively from both fundamental and technical standpoints.
SPS Commerce (SPSC) is a $3B market cap provider of supply chain management software for omni-channel retailers, suppliers, distributors, and logistics companies. Its cloud-based SaaS offerings improve how customers manage and fulfill orders. From an estimated total addressable market of $5B, it has a share of 5%. SPS derives 94% of its revenues from recurring subscriptions and has more than 31K recurring customers. It has generated revenue growth for 78 consecutive quarters and has a trailing five-year revenue CAGR of 17%. Over these five years, adjusted EBITDA margins have risen to 25% from 14%, and the company targets 35% in the long term.
LGI Homes LGIH (LGIH) is a $3B market cap homebuilder in the central (40% of revenues), southeast (20%), northwest (15%), west (15%), and Florida (10%) regions of the U.S. It focuses on first-time buyers with an average selling price of $240,000. It has double-digit revenue CAGR across all five geographies, both organically and through acquisitions, including that of Wynn Homes in 2018. The shift to work-from-home has accelerated home loan applications, accompanied by ongoing low mortgage rates. LGI expects to close 8,000‒8,800 homes in 2020, with adjusted gross margin of around 26%. Consensus expects 30% EPS growth in 2020 and 15% in 2021.
Blackline (BL) is a $6B market cap provider of cloud-based software that automates and streamlines finance and accounting processes. The total addressable market for this growing segment is $19B, and Blackline has a <2% share of both revenues and customers. Through Q2 2020 the company had 3,100 customers, a 12% increase from the prior year. It won the backing of SAP SAP in 2018, signing an agreement in which SAP will resell its software to Blackline’s customers worldwide. The company has five-year average revenue growth of 42%, while earnings turned positive in 2018 and quickly accelerated in 2019. Consensus expects 27% EPS growth in 2020 and 11% in 2021.
Yeti (YETI) is a $4.5B market cap provider of outdoor products, including ice chests, soft coolers, insulated drinkware, and backpacks. Drinkware accounts for two-thirds of its sales and other equipment for the remainder. It sells through the wholesale (50% of revenues) and direct-to-customer (DTC, 50%) channels. When the COVID-19 lockdown began in March, yeti.com sales were up more than 100% in the first two months. This higher-margin segment contributed to a 550bps increase in gross margins in Q2 2020 and drove an earnings surprise of more than 100% in the quarter. For the next six quarters, consensus expects average top-line growth of 15%, in line with three-and-five-year averages, and EPS growth should top 20% for the next two years.
Neogenomics (NEO) is a $5B market cap oncology laboratory testing services provider and a leader in molecular and next-generation sequencing (NGS) testing that serves more than 2,600 hospitals and cancer centers with more than 1M annual tests. It estimates the addressable oncology testing market to be $6B, growing 6‒8% annually. Sales have grown 32% for the past five years. Despite a down Q2 2020 resulting from global lockdowns, top-line growth is expected to jump back up to 20%+ for the next four quarters. Earnings should also return to growth in a big way in 2021.
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