Has the Long-Awaited Small-Cap Rally Finally Arrived?
Stock market trends last longer than anyone expects.
That was the oft-repeated adage of my former boss, Cabot legend Tim Lutts. And he was right. For all the tsk-tsking about the current bull market being long in the tooth, it’s actually tied for the shortest bull market (21 months) in history at the moment, according to data from Ryan Detrick of Carson Research Group. The average bull market lasts 61 months – nearly three times the length of the current one!
The same is true of bear markets, of course. The average bear market lasts 289 days, or nine and a half months. And that was almost exactly the length of the 2022 bear market, which began at the end of 2021 and lasted until mid-October of 2022 (although it dragged on even longer than that for growth stocks).
Then there’s the simple trend of “underperformance.” We’ve seen sustained underperformance in value stocks, which have underperformed growth stocks for more than a decade now. Chinese stocks have never fully recovered since Covid. And then there are small-cap stocks.
Historically, small-cap stocks outperform their large-cap brethren – in three out of every five years, according to our small-cap expert, Tyler Laundon. But not in the last five years. Since July 2019, the Russell 2000 (which tracks small caps) has trailed the S&P 500 by almost a 2-to-1 deficit, up 46% vs. an 89% gain in the large-cap index.
Now, small caps would never be confused with value stocks, at least not collectively. Their very nature – young, up-and-coming companies many of which are not yet profitable – makes them more speculative than easily measurable. And yet, as of June 30, the Russell’s price-to-earnings ratio excluding companies with negative earnings (big caveat, to be sure) was 16.9 – its cheapest valuation since the Great Recession in 2008.
Given that backdrop, surely the tide had to turn eventually … right?
Small-Cap Rally Under Way?
Well, it seems to be turning. Seemingly overnight, small caps are on fire – up more than 11% in the last week, with five straight up days prior to Wednesday’s trading. Unlike the S&P or the Nasdaq, the Russell still trails its late-2021 highs. But it’s gaining on it – fast.
So what changed? The Fed.
OK, so the Fed didn’t change exactly. But better-than-expected inflation numbers last week prompted some fairly dovish talk from Jerome Powell (by his standards), prompting economists to all but pencil in the first interest rate cut in September – the CME Group’s FedWatch Tool now puts the odds of at least one rate cut by the September meeting at 98%, up from roughly 66% just a couple weeks ago. Interestingly, the large-cap indexes are flat (S&P) to down (Nasdaq) in the week since the CPI print, while small caps are up double digits. Could it be a changing of the guard?
Here’s my take: Small caps have merely been a microcosm of “the rest of the market” outside of the Magnificent Seven and a handful of leading artificial intelligence stocks. Indeed, the performances of the Russell 2000 and the Equal Weight S&P Index have been almost identical since the start of 2022; both are up marginally (less than 5%), with virtually all of their gains coming in the past week.
Essentially, the Russell is simply the S&P 500 minus the 10 mega-cap tech stocks that have been propping it up for the last 21 months. We’ve written several times in this space about how nine of the 11 S&P sectors are undervalued despite the market being at all-time highs. The same goes for small caps. So now that the tide appears to – maybe, possibly – be shifting from the Mag. 7/AI to everything else (including many of our portfolio holdings – see below!), small caps – perhaps due to their higher upside and general history of outperformance – are leading the charge.
So yes, with rate cuts now finally in sight (it seems), I believe the long-awaited small-cap rally has arrived. Thus, I’ll be on the lookout for potential small-cap additions to our Growth/Income Portfolio in the coming weeks.
Note to new subscribers: You can find additional commentary on past earnings reports and other news on recommended companies in prior editions and weekly updates of the Cabot Value Investor on the Cabot website.
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This Week’s Portfolio Changes
Agnico Gold Mines (AEM) – Moves from Buy to Sell (reached price target!)
Last Week’s Portfolio Changes
CNH Industrial (CNH) – Moves from Buy to Hold
Upcoming Earnings Reports
Tuesday, July 23 – Philip Morris International (PM)
Thursday, July 25 – NOV, Inc. (NOV)
Growth & Income Portfolio
Growth & Income Portfolio stocks are generally higher-quality, larger-cap companies that have fallen out of favor. They usually have some combination of attractive earnings growth and an above-average dividend yield. Risk levels tend to be relatively moderate, with reasonable debt levels and modest share valuations.
Canadian Solar Inc. (CSIQ) is not only Canada’s largest solar energy company; it’s a global leader in the solar space. And it’s gotten much larger in the last two years, since the Canadian government announced a 50% income tax cut for zero-emission technology manufacturers (which the new 2023 legislation extended by three years). Canadian Solar’s revenues were up 41.5% in 2022, another 2% in 2023 (both record highs), and are on track to tack on another 1.2% this year and a whopping 20.2% in 2025. If it meets those estimates, the company will have gone from $3.5 billion in annual revenues to $8.25 billion in just five years. Earnings per share have more than doubled since 2021, and while they’re expected to take a step back this year, they’re projected to reach new highs of $4.75 per share next year.
And the company is right in the sweet spot for the North American solar boom. It manufactures solar photovoltaic modules and runs large-scale solar projects across Canada, and in 29 other countries, even spinning off a subsidiary – CSI Solar Ltd. – last year that trades on the Shanghai Stock Exchange. The company boasts 61 gigawatt (GW) module capacity, is up to 125GW solar module shipments, and has a project pipeline of 26.3GW. That doesn’t include its battery storage shipments (4.5 GW hours, or GWh) or capacity (20GWh expected by year’s end).
It’s a big company that operates on a global scale, and it’s growing fast. And yet … the stock is a small cap, with a market capitalization of a mere $1.1 billion. It used to be four times as big, trading as high as 63 a share in January 2021. Today, it trades at 16 a share, and at 7x forward earnings, 44% of book value, and a paltry 0.16x sales. The latter two numbers are the cheapest the stock has ever been.
There was no company-specific news for Canadian Solar this week, though the stock continued its steady recovery, up another 5%. Having fallen from a hair under 20 all the way to 14 in June, the tick back up toward the high 16s qualifies as real progress; perhaps the worst is over for CSIQ and solar stocks as a group. I’ve been writing for weeks that the selling in renewable energy stocks is way overdone, with the WilderHill Clean Energy ETF (PBW) dipping to seven-year lows, and 85% below its early-2021 peak. While renewable energy stocks have a checkered history, they’ve rarely been this cheap, and Canadian Solar is one of the fastest growing of the bunch. The aforementioned rally in small-cap stocks is surely lending a hand in the turnaround at the moment.
CSIQ shares have a whopping 68% upside to our 28 price target. BUY
Dick’s Sporting Goods (DKS) has been growing steadily for years.
From 2016 to 2023, the sporting goods chain’s revenues have improved 64%, from just under $8 billion to just under $13 billion. This year, the top line is on track to top $13 billion for the first time. It should top $13.5 billion next year.
Dick’s, in fact, has grown sales in each of the last seven years – including in 2020 and 2021, when most other retailers saw sales nosedive due to Covid restrictions. But Dick’s all-weather ability to keep growing no matter what’s happening in the world or the economy speaks to its versatility. Since Covid ended, however, Dick’s sales have entered another stratosphere. As youth sports returned in 2021, Dick’s revenues jumped from $9.58 billion to $12.29 billion. They’ve been rising steadily each year since and are expected to do so again this year.
But Dick’s isn’t purely a growth stock—it’s also undervalued. DKS shares currently trade at 17x forward earnings estimates and at 1.45x sales. To be sure, it’s not the cheapest stock in our portfolio. But it is one of the fastest growing – and pays a solid dividend to boot.
Dick’s had a very good second week in our portfolio, up 10%!
There was no company-specific news, although the better-than-expected June retail sales report from earlier this week surely helped. So did the lower inflation report. Declining inflation and resilient retail sales are a more palatable narrative for investors who have been skittish about buying retail stocks of late. But Dick’s has been growing just fine anyway, so it may have been at the front of the queue when institutions started snatching up retail stocks in the last week (the 10% run-up in DKS shares is quadruple the 2.5% gain in the XRT Retail ETF in the last five trading days).
We set a price target of 250, which is starting to feel rather modest – a mere 14% leap from the current price. Keep a close eye on the 230 level, which has acted as consistent resistance for DKS shares, and did so again earlier this week.
So far, so good with this stock that’s a bit more growth than value. BUY
Honda Motor Co. (HMC) – After years of declining sales, Honda was rejuvenated in 2023 thanks to hybrids. The Japanese automaker sold 1.3 million cars last year, up 33% from 2022; a quarter of the cars it sold were hybrids, led by its popular CR-V sport utility vehicle (SUV) and Accord mid-size sedan. The CR-V was the best-selling hybrid in the U.S. last year, with 197,317 units sold. The Accord wasn’t far behind, with 96,323 sold. All told, Honda’s hybrid sales nearly tripled in 2023, to 294,000 units.
So, Honda is making the full pivot to hybrids, with the Civic soon to become the latest addition to its hybrid fleet. Investors have started gravitating more to the companies that sell them. Invariably, those are well-established, big-name car companies made famous by many decades of selling internal combustion engine vehicles; most aren’t ready to fully abandon their roots but want to tap into the surging national (and global) appetite for electric, so they instead are turning to hybrids as a compromise. As a result, these once-stodgy car companies are tapping into new revenue streams, and their share prices are surging accordingly.
Among the hybrid-rejuvenated, brand-name automakers, Honda offers the best value.
Honda is collaborating with Nissan to co-develop electric vehicle software and build charging networks in an effort to reduce costs and develop new technologies. It’s the latest evidence of Honda prioritizing beefing up its electric/hybrid offerings and capabilities. The news was minor enough that it hasn’t moved the needle a ton for HMC shares, though they were up 1.5% this week. Still, the stock remains in the same 31-32 range it’s been in for more than a month. The Nissan deal could have a noticeable impact down the road, however.
HMC shares have 38% upside to our 45 price target. The 4.1% dividend yield adds to the appeal. BUY
Philip Morris International (PM) – Based in Connecticut, Philip Morris owns the global non-U.S. rights to sell Marlboro cigarettes, the world’s best-selling cigarette brand. Cigarettes comprise about 65% of PMI’s revenues. The balance of its revenues is produced by smoke-free tobacco products. The cigarette franchise produces steady revenues and profits while its smoke-free products are profitable and growing quickly. The upcoming full launch of IQOS products in the United States, a wider launch of the IQOS ILUMA product and the recent $14 billion acquisition of Swedish Match should help drive new growth.
The company is highly profitable, generates strong free cash flow and carries only modestly elevated debt (at about 3.2x EBITDA) which it will whittle lower over the next few years. The share valuation at about 15.4x EBITDA and 16.9x per-share earnings estimates is too low in our view. Primary risks include an acceleration of volume declines and/or deteriorating pricing, higher excise taxes, new regulatory or legal issues, slowing adoption of its new products, and higher marketing costs. A strong U.S. dollar will weigh on reported results. While unlikely, Philip Morris could acquire Altria, thus reuniting the global Marlboro franchise.
PM shares were up 6% ahead of next Tuesday’s (July 23) earnings report. Analysts are anticipating 6% sales growth with EPS essentially flat year over year, though there are early indications that the company may beat bottom-line estimates as it has done in three of the last four quarters. Meanwhile, the company plans to boost production of its popular Zyn nicotine pouches by breaking ground on a new $600 million manufacturing facility in Colorado.
PM shares still have 11% upside to our 120 price target. The 4.9% dividend yield adds to the now double-digit return since the stock was added to the portfolio last September. BUY
United Airlines (UAL) – People are flying in planes again in Covid’s aftermath, and no major airline is taking advantage of it quite like United.
United Airlines is the fastest-growing major U.S. airline. The third-largest airline carrier in the world by revenues behind Delta (DAL) and American (AAL), United is expected to grow sales by 7.4% in 2024 – more than its two larger competitors – and that’s with revenues already topping a record $50 billion in 2023 – 19.6% higher than in 2022, which was also a record year. For United, business has not only returned to pre-pandemic levels; it’s better.
Meanwhile, the stock is super cheap. It trades at less than 5x forward earnings estimates, with a price-to-sales ratio of just 0.29 and a price-to-book value of 1.68. The stock peaked at 96 a share in November 2018; it’s currently in the upper 40s.
A company that’s making more money than ever before (gross profits reached a record $15.2 billion last year, though earnings were still second to 2019 levels on a per-share basis), and yet its stock trades at barely more than half its peak from five and a half years ago. A true growth-at-value-prices opportunity.
United Airlines reported earnings after the close yesterday – and after our publication deadline. The stock was unmoved at 47 prior to the report, so we’ll see how it responds today and in the coming days. Analysts were looking for 6.2% revenue growth with a 22% EPS decline. Hopefully, the real numbers came in above those rather pedestrian estimates. If not – and the stock falls below 44 support – we may have to reassess. For now, we will maintain our Buy rating, with a price target of 70. BUY
Buy Low Opportunities Portfolio
Buy Low Opportunities Portfolio stocks include a wide range of value opportunities. These stocks carry higher risk than our Growth & Income stocks yet also offer more potential upside. This group may include stocks across the quality and market cap spectrum, including those with relatively high levels of debt and a less clear earnings outlook. The stocks may not pay a dividend. In all cases, the shares will trade at meaningful discounts to our estimate of fair value.
Agnico Eagle Mines (AEM) shares have reached our price target of 75!
In fact, the stock closed above 76 Tuesday before pulling back a bit on Wednesday. It’s the highest peak for AEM since it reached all-time highs above 84 in late 2020.
What to do now? I think it’s time to sell. The biggest contributor to Agnico’s strength this year has been resurgent gold prices, which are now touching new record highs above $2,470 an ounce. AEM’s shares are no longer value-priced, trading at 22.5x forward earnings, 5.5x sales and 1.94x book value. So, I say we pocket the 35% return in less than four months and deploy it on an asset class that has more upside, as the gold mining trade may be right on the brink of maxing out. MOVE FROM BUY TO SELL
Aviva, plc (AVVIY), based in London, is a major European company specializing in life insurance, savings and investment management products. Amanda Blanc, hired as CEO in July 2020, is revitalizing Aviva’s core U.K., Ireland and Canada operations following her divestiture of other global businesses. The company now has excess capital which it is returning to shareholders as likely hefty dividends following a sizeable share repurchase program. While activist investor Cevian Capital has closed out its previous 5.2% stake, highly regarded value investor Dodge & Cox now holds a 5.0% stake, providing a valuable imprimatur and as well as ongoing pressure on the company to maintain shareholder-friendly actions.
Aviva shares have broken to new highs above 12.7!
After months of being rebuffed every time it neared 12.7, the stock finally beat down the door last Thursday, stretching to 12.8 for the first time since May 2022. Why the sudden strength? It finalized a 249 million-pound deal to buy Probitas, which should expand Aviva’s market reach in its global corporate and specialty division. For a company that rarely has any relevant news, it was enough to push AVVIY shares to a two-year high, up 4% in the last week. Still, shares of the U.K.-based life insurance and investment management firm remain cheap, trading at less than 12x earnings estimates, with a price-to-sales ratio of 0.41. Shares have 10% upside to our 14 price target. The 6.6% dividend yield adds to our strong total return thus far. BUY
CNH Industrial (CNH) – This company is a major producer of agriculture (80% of sales) and construction (20% of sales) equipment and is the #2 ag equipment producer in North America (behind Deere). Its shares have slid from their peak and now trade essentially unchanged over the past 20 years. While investors see an average cyclical company at the cusp of a downturn, with a complicated history and share structure, we see a high-quality and financially strong company that is improving its business prospects and is simplifying itself yet whose shares are trading at a highly discounted price.
CNH shares had an excellent bounce-back week, rising 11% to reach their highest point since May!
There was no company-specific news, although the stock likely got a boost from the cooler-than-expected inflation report last week as the bull rally finally spread to the scores of unloved sectors and stocks. CNH shares are still down sharply since an underwhelming earnings report in late April, but the company has a chance to redeem itself in a couple weeks when it reports Q2 earnings on July 31.
We downgraded CNH to Hold last week after what was essentially three straight months of selling. And we’ll keep it right there despite the big run-up this week. Further gains, particularly if they’re aided by a strong second-quarter report, could have us quickly moving back to Buy. HOLD
Gates Industrial Corp, plc (GTES) – Gates is a specialized producer of industrial drive belts and tubing. While this niche might sound unimpressive, Gates has become a leading global manufacturer by producing premium and innovative products. Its customers depend on heavy-duty vehicles, robots, production and warehouse machines and other equipment to operate without fail, so the belts and hydraulic tubing that power these must be exceptionally reliable. Few buyers would balk at a reasonable price premium on a small-priced part from Gates if it means their million-dollar equipment keeps running. Even in automobiles, which comprise roughly 43% of its revenues, Gates’ belts are nearly industry-standard for their reliability and value. Helping provide revenue stability, over 60% of its sales are for replacements. Gates is well-positioned to prosper in an electric vehicle world, as its average content per EV, which require water pumps and other thermal management components for the battery and inverters, is likely to be considerably higher than its average content per gas-powered vehicle.
The company produces wide EBITDA margins, has a reasonable debt balance and generates considerable free cash flow. The management is high-quality. In 2014, private equity firm Blackstone acquired Gates and significantly improved its product line-up and quality, operating efficiency, culture and financial performance. Gates completed its IPO in 2018. Following several sell-downs, Blackstone has a 27% stake today.
Gates shares were up a whopping 16.5% in the last week on no news other than that the company will join the S&P Small-Cap 600 index starting next week. The real reason behind the move is likely similar to what happened with CNH: bull market breadth is finally expanding, and buying has spread to the many underperforming sectors.
CNH, however, has not been an underperformer for us; it’s our best performer in terms of overall return, up 65% since it was added to the portfolio just under two years ago. And the stock still has 13% upside to our 20 price target.
Trading at just over 12x forward earnings and at 1.3x sales, it’s still cheap. BUY
NOV, Inc (NOV) – This high-quality, mid-cap company, formerly named National Oilwell Varco, builds drilling rigs and produces a wide range of gear, aftermarket parts and related services for efficiently drilling and completing wells, producing oil and natural gas, constructing wind towers and kitting drillships. About 64% of its revenues are generated outside of the United States. Its emphasis on proprietary technologies makes it a leader in both hardware, software and digital innovations, while strong economies of scale in manufacturing and distribution as well as research and development further boost its competitive edge. The company’s large installed base helps stabilize its revenues through recurring sales of replacement parts and related services.
We see the consensus view as overly pessimistic, given the company’s strong position in an industry with improving conditions, backed by capable company leadership and a conservative balance sheet.
There was no company-specific news for NOV this week, but the stock – like CNH and GTES – was up double digits nonetheless, rising 11%! The company will report earnings a week from today, July 25.
The energy sector has improved of late, with crude oil prices up to $82 a barrel after reaching as low as $73 a month ago. NOV shares got an initial bump, sagged right back, and are now getting another strong push to advance to their highest point since early April. What a difference a week makes!
NOV has 22% upside to our 24 price target. It trades at just 12.6x forward earnings estimates and 0.88x sales, with a modest 1.2% dividend yield helping the cause a bit. After almost no movement for the 14-plus months since it was added to the portfolio, this past week’s 11% run-up was encouraging and restored our faith in the stock a bit. But the real test may come a week from now, when the company reports earnings. Stay tuned! BUY
Growth/Income Portfolio | |||||||
Stock (Symbol) | Date Added | Price Added | 7/17/24 | Capital Gain/Loss | Current Dividend Yield | Price Target | Rating |
Canadian Solar Inc. (CSIQ) | 6/6/24 | 18.95 | 16.16 | -14.70% | N/A | 28 | Buy |
Dick’s Sporting Goods (DKS) | 7/5/24 | 200.1 | 215.87 | 7.89% | 1.90% | 250 | Buy |
Honda Motor Co. (HMC) | 4/4/24 | 36.34 | 32.6 | -11.70% | 4.10% | 45 | Buy |
Philip Morris International (PM) | 9/18/23 | 96.96 | 107.88 | 11.30% | 4.90% | 120 | Buy |
United Airlines (UAL) | 5/2/24 | 50.01 | 46.8 | -6.00% | N/A | 70 | Buy |
Buy Low Opportunities Portfolio | |||||||
Stock (Symbol) | Date Added | Price Added | 7/17/24 | Capital Gain/Loss | Current Dividend Yield | Price Target | Rating |
Agnico Eagle Mines (AEM) | 3/25/24 | 56.31 | 75.5 | 34.10% | 2.40% | --- | Sell |
Aviva (AVVIY) | 3/3/21 | 10.75 | 12.74 | 18.50% | 6.80% | 14 | Buy |
CNH Industrial (CNH) | 11/30/23 | 10.74 | 10.59 | -1.40% | 4.40% | 15 | Hold |
Gates Industrial Corp (GTES) | 8/31/22 | 10.72 | 17.79 | 66.00% | N/A | 20 | Buy |
NOV, Inc (NOV) | 4/25/23 | 18.19 | 19.63 | 7.90% | 1.20% | 25 | Buy |
Note for stock table: For stocks rated Sell, the current price is the sell date price.
Current price is yesterday’s mid-day price.
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