Small-cap stocks have fared worse than their larger peers in the recent market sell-off. Bank of America says small cap growth is increasingly synonymous with companies that lose money. Strategist Jill Carey Hall says it’s still possible to find cheap, profitable small cap growth. The main appeal of investing in smaller companies is that they have more room to grow, which can translate into better stock performance than the biggest companies can offer.
That’s the theory, anyway. Today, however, investors are clearly nervous about small caps as interest rates rise. That’s especially true when it comes to the companies that aren’t making consistent profits, and as Bank of America’s Jill Carey Hall noted in a recent report, those unprofitable stocks are becoming synonymous with small caps.
“The Russell 2000 Growth has become lower quality than ever (45% non-earners),” wrote Carey Hall, the bank’s head of US small and mid cap strategy. And while investors are looking for stability in a volatile market they’ve been dumping small-cap growth and shifting into value-type stocks, as they’re doing in other parts of the market.
But she writes that investors don’t really have to choose between growth stocks and more stable stocks, and the broad selling has created some bargains.
“Russell 2000 Growth now looks historically cheap vs. Russell 2000 Value, and has also seen better recent revisions and better expected N12m [next 12-month] EPS and sales growth,” she said.
Carey Hall says investors can thread that needle — finding smaller companies that are cheap and have good growth prospects but aren’t losing money — by focusing on quality metrics like earnings stability and balance sheet health. That’s been working well recently, and according to Carey Hall it was one of the best ways to add alpha in small caps last month.
She also suggests blending growth with quality because it tends to perform well later in the economic cycle, and Bank of America thinks the current expansion is in its later stages.
“We include a screen of 28 Russell 2000 stocks that our analysts recommend (Buy) and that screen well on a combo of Growth and Quality factors that fare well in the current backdrop (we prefer cyclical growth factors like Revisions and Surprise, plus high or expanding margins),” she said.
The list below includes stocks from seven of the 11 major market sectors, and while Carey Hall emphasizes growth, the first 13 entries are also in BofA’s top 20% of small caps companies based on some traditional value metrics — specifically free cash flow to price or free cash flow to enterprise value.