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Small-Cap Stocks Lead in 2016

The market has bounced back in 2016, and small-cap stocks have led the way. With more earnings growth on the horizon, the rally in small caps may just be getting started.

Three Legs of the Small-Cap Investing Roadmap

A good deal of investing success comes from having a simple plan that puts you in a position to profit. The rest is executing the plan and having enough conviction to not jump ship. This can be particularly challenging with more volatile equities including small-cap stocks and biotech stocks.

To capture the outsized gains that these stocks often deliver, investors need to stay the course. And one of the ways to do so is to check in on your plan periodically throughout the year.

Skipping this crucial step is like throwing the GPS (who uses a paper map these days?) out the window immediately after taking off on a cross-country drive. How do you know where to go next if you don’t know where you are?

While it sounds simple and reasonable to develop an investing roadmap and check progress along the way, it’s easier said than done for many do-it-yourself investors. Work, family and life’s occasional curveballs are all valid reasons why many investors (professionals included) don’t have the time or focus to come up with that investing plan to begin with.

That’s why I publish an annual strategy report at the beginning of every year for Cabot Small-Cap Confidential 2.0 subscribers. I come up with the plan so subscribers don’t have to!

Whether you’re a subscriber to the service or not, a mid-year check point will help you make more money in the second half of 2016.

So here are three legs of the small-cap investing roadmap I laid out for subscribers in January, along with a few suggestions that I think can lead to profits in the second half of 2016.

Small-Cap Stocks Lead in 2016

At the end of January 2016 I wrote:

Small caps will outperform large caps in 2016. After rising for five of the six years between 2009 and 2014, small caps (and large caps, for that matter) hit a wall of worry in late 2015. They have slid down that wall in the first month of 2016. The first half of the year will continue to be scary but not the beginning of a recession in small caps or the U.S. economy. Given that small caps outperform over the long-term, yet have underperformed large caps for two consecutive years (2014 and 2015), and have fallen so much year-to-date, I see solid potential for small-cap outperformance over the next 12 months.”

At that time in 2016, large caps were down 7% and small caps were down 9%. It didn’t feel like a bull market for either of them!

But the market looked oversold and the fundamentals for small-cap stocks looked solid. Also, small-cap stocks were coming off two years of relative underperformance (see chart below), which alone suggested that they were poised to rally.

And they have rallied 13% since February 1. Plus with the S&P 600 Small Cap Index just breaking through resistance, they look poised to keep rallying. Investors should stay the course with small-cap stocks.

Earnings Growth Ignites a Virtuous Cycle

A lot of investors don’t follow fundamentals. After all, if a stock is going up (or down), what else matters? On the flipside, it’s easy to get bogged down in the details if you’re overly concerned with the numbers.

Of course, it doesn’t pay to go to either extreme.

But there are a few metrics that matter a lot because the market tends to revert back to averages over time.

With this in mind, at the end of January 2016, I predicted:

Small caps will once again trade in a range of 17 to 18 times forward earnings by the end of 2016. At the end of 2014 and beginning of 2015, small caps became overvalued, trading up to over 19-times forward earnings estimates. A more normal range during stable periods of economic growth is 16 to 18 times forward earnings. Today, they are comparatively cheap, trading with a P/E of less than 16. A P/E of 18 would imply the index should trade near 700 today. However, that’s based on current 2016 expected earnings. By the middle of the year, the index’s valuation should be factoring in expected earnings growth in the first half of 2017.

Sure enough, small caps rallied into first-quarter earnings season and, as analysts raised forward earnings estimates from overly bearish predictions, forward growth prospects began to validate a higher price-to-earnings (P/E) valuation.

This is a virtuous cycle that I think passes over the heads of many investors. All things being equal, when a stock index rises, the forward-P/E ratio rises as well. But, when forward earnings forecasts increase, the denominator of the price-to-earnings ratio goes up too, so it slows the rate of increase of the forward P/E ratio. And, faster growth typically justifies a higher valuation. It’s basic math.

And it explains why a chart of the implied P/E ratio for the S&P 600, as presented below (courtesy of Yardeni Research) is so valuable when assessing the current state of small-cap stocks. The blue arrow in the chart below indicates when I wrote my small-cap stock forecast in early 2016.

Right now, small caps look to be fairly valued (if not a little expensive) with a forward P/E around 18 based on current forward earnings estimates. But earnings estimates are on the rise, aided by improving prospects for energy and basic materials, and reaccelerating growth in health care and technology. The P/E ratio can go up a little, but a move into the 20s would be a yellow flag.

Right now, it’s important for investors to pick their stocks and sectors more carefully than they could get away with earlier in the year. Health care and biotech are good places to start.

So where does this leave us? Where are small-cap stocks headed over the remainder of 2016? Let’s maintain the beginning-of-the-year target, when I wrote:

The S&P 600 will end 2016 at 730. The S&P 600 Small Cap Index ended 2015 at roughly 665, and traded as low as 602 in January. Assuming the above scenarios play out (small caps benefit from at least two more rate hikes, earnings growth remains stable and small caps trade back to near a P/E of 17 to 18 by year-end), the index should be able to hit 730 by year end (10% higher from the start of the calendar year). That’s within arm’s grasp of the 2015 high of 742. And it’s also 18% higher from where the index is today.”

With small-cap stocks up 6% so far, my target implies they’ll finish the year up another 3%. That’s not a ton of upside, but I think it’s a fairly conservative target. And it would put small caps on track for another good year in 2017, when I think they can close at all-time highs.

In such a market, individual stocks in leading sectors are sure to do much better. And that’s my mission in Cabot Small-Cap Confidential 2.0. We have a roadmap based on a few predictions and we’re following it, and while we all certainly reserve the right to make detours along the way, thus far, all is going according to plan.

My last four small-cap stock recommendations are up an average of 17%! And with a little luck, we’ll continue to beat the market moving forward.

If you could use a little guidance plotting your own course to investing success, and you like the profit potential of small-cap stocks, I’d love to be your guide. We’ve just opened the doors for new subscribers to Cabot Small-Cap Confidential 2.0 for a short while, so you have the opportunity to jump in. I’m confident we’ll continue to find opportunities that deliver big gains, even if we have to go off-route a few times.

Get more details here.

Tyler Laundon is chief analyst of the limited-subscription advisory, Cabot Small-Cap Confidential and grand slam advisory Cabot Early Opportunities. He has spent his entire career managing, consulting and analyzing start-up and small-cap companies. His hands-on experience has taught Tyler that the development of a superior business model is the biggest factor in determining a company’s long-term success. Accordingly, his research focuses on assessing the viability of management’s growth strategies, trends in addressable markets and achievement of major developmental milestones.