Buttressing optimism for the category is its immunity from the market’s trade-war fears: Small companies don’t tend to export much. Another factor is the tendency for economic expansion to increase earnings more down cap than up. Further, the delayed benefits of the tax cut should help domestic-centric companies proportionately more than multinationals. Small caps, which tend to pay higher effective tax rates, receive proportionately more tax relief from the legislation.
These factors doubtless will provide an extra boost for small companies that are already on the rise — and benefit investors looking for value in individual stocks. In a market where investors are constantly assaulted by data on large caps, many small companies aren’t widely known. This makes them perennial fodder for the craft and sullen art of astute stock pickers seeking to exploit market inefficiencies. Typically, small caps on the launching pad or even taking off receive little or no touting from Wall Street, whose sell-side analyst ranks are thinning because of investment flows from active to passive management.
An estimated 45 percent of small-cap companies now have no analyst coverage whatsoever, and only about 20 percent have as many as five analysts covering them. And because of liquidity constraints, large small-cap funds tend to limit their purchases to larger small companies with sufficient trading volume — those with market caps above $500 million. Though these may not be covered by any analysts, inclusion in large funds can bring attention, while smaller small caps have a much lower profile. The paucity of analysts covering these companies is doubtless slowing the already glacial speed of information about them.
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For individual investors, the resulting market inefficiencies come with a conundrum. If news about the merits of potential winners travels slowly, how can they learn about it before it pushes up prices? How can they find and evaluate small companies that may be prospering, unbeknownst to most of the market?
Here are some moves to consider in the search for those hidden small-cap gems.
1. Pay especially close attention to volatility. Volatility can be friendly to small-cap value investors. If past periods of high volatility hold true, this year’s herky-jerky market will likely foster a repeat of the baby-out-with-the-bathwater effect, in which lower trading volume punishes price disproportionately for small companies. This can create value opportunities for informed investors lying in wait for price dips.
2. Learn to use new tools available on low-profile radar screens. Some online screens providing myriad data are free of charge. To that point, CNBC.com has a free stock screener that’s highly configurable. For example, an effective search for high-performing small companies with low profiles could use these five screens:
- Market cap under $500;
- Year-over-year revenue growth greater than 10 percent;
- One-year EPS growth greater than 15 percent;
- P/E ratio of 15 or less; and
- Coverage by two or fewer analysts.