Small-cap stocks are back. If the trend continues — which is my guess — there are more big gains to be made because the group has been so badly hammered. I suggest five under $5-per-share names below.
First, about that small-cap snapback. This is the early stage of a new bull market for small-company stocks. Once the S&P 500 rises more than 20% off a market bottom (which just happened), it keeps going up over the next year 92% of the time — posting 19% returns on average, notes Savita Subramanian, head of U.S. equity strategy & U.S. quantitative strategy at Bank of America Merrill Lynch. This matters, because as investors figure this out and enjoy the ride they will get more confident – shifting to more “risk on” asset classes like small-caps.
Plus, U.S. interest rates are becoming more normal. Near-zero real rates have been a headwind for small-caps. Low rates favor “long-duration” assets like the tech- and biotech stocks that have a lot of their earnings pay off in the distant future. Low discount rates in valuation models make long-duration assets look cheaper. Now that is changing, and small-caps will benefit, says James Stoeffel, a manager of the Royce Small-Cap Opportunity Fund
During the Great Financial Crisis, both large-caps and small-caps fell by roughly the same amount. Last year, small-caps fell a lot more, notes Kevin Rendino, CEO and portfolio manager at 180 Degree Capital which specializes in small-cap turnarounds. The upshot: Small-caps are as cheap relative to large-caps. The p/e for small-caps is around 75% that of large-caps, compared to 100%-120% over the period from 2008 to 2020. “This makes little sense to us, and it creates tremendous buying opportunity,” Rendino says.
Cheap valuations rarely tell you when a group will outperform. But the deep discount tells you a group will likely outperform by a lot once it gets rolling, notes Michael Corbett of Perritt Capital Management, which specializes in investing in small companies.
Diversify in small caps
I’ve noticed over three decades of writing about U.S. markets that many investors develop a deep fascination with sub-$5 stocks whenever animal spirits prevail. That’s understandable; under-$5 stocks can produce big percentage gains, fast. Many companies with low-priced stocks need a turnaround, and when you find one making positive changes, the gains can be impressive. Finally, many sub-$5 stocks are uncovered by Wall Street. Bullish developments are less likely to be priced in, so you can find good bargains.
If you get bitten by the sub-$5 bug, just keep this in mind: these stocks are risky. Do not take concentrated positions. Royce Small-Cap Opportunity, for example, holds around 250 stocks and the median position size is just 0.37% of the portfolio. The fund caps its positions at 1%. “You should look to have a fair level of diversification,” Stoeffel cautions.
Below are five under-$5 stock holdings chosen by the fund managers who shared their insights above. Avoid buying these stocks if they move above the limit price. These bounce around a lot and you don’t want to buy a spike.
Buy limit: $3
Back in 1921, Anna “Mama” Mancini moved to Bay Ridge, Brooklyn, from Bari in southern Italy. Her old-world Italian recipes were handed down to her grandson, Dan Dougherty. Those treats formed the basis of this food company he founded. It now sells over 50 different all-natural lines of food to grocery stores and distributors. The company markets on QVC and its products are available at Walmart, Costco Wholesale and Albertsons, among others.
The stock got hurt during the past two years by supply chain issues and inflation. But it has fixed supply chains and tackled the inflation issue by raising prices and is growing via acquisition. MamaManicini’s closed at the $3 buy-limit on Friday.
Buy limit: $4.10
The job market remains tight. This favors recruiters like DHI. It specializes in two areas where there is a scarcity of available workers: Tech, and jobs that require government security clearances. DHI gets its revenue from companies who pay subscription fees to post jobs on its websites Dice and ClearanceJobs, and search its databases for employees.
Dice has 8,300 subscribers who offer 7.5 million job candidates. That makes DHI one of the largest tech recruiters in the U.S., says James Harvey, another Royce Small-Cap Opportunity manager. These customers like the service. The subscription renewal rate is 93%.
DHI stock has been hit recently because new customer adds have flattened. That should change, Harvey says, because of projected tech-worker shortages. DHI estimates there will be a shortfall of five million workers to fill the 30 million tech jobs expected by 2026. ClearanceJobs has more than 2,000 subscribers and it continues to grow, recently at 15% year over year.
Buy limit: $1.10
Quantum offers data storage and management products. It specializes in products that help store and search video, images, scientific data and other large datasets. This makes it a play on the mega-trends of AI, machine learning, and data analytics. Its products are also used in video editing, streaming, and high-speed backup.
Though this company faces competition from giants like the EMC division of Dell Technologies, International Business Machines and NetApp Rendino at 180 Degree Capital says Quantum has competitive offerings.
“This is the year where they show they can grow the business and margins or they will have to sell the company,” Rendino says. As an activist manager, he plans to push in that direction, if needed. “The company may be too small to be public,” he says. The implication is that either scenario — continued growth or a sale — would benefit shareholders.
4. Heritage Global (HGBL)
Buy limit: $4.10
Heritage Global is a liquidator. It picks up unwanted equipment, real estate and inventory from companies that are streamlining or going out of business. Then it re-sells the goods. The company has another division that assumes bad loans from banks and uncollected receivables. Then it attempts to collect.
Economic downturns like this one bring in more business. U.S. bankruptcies increased 38% year-over-year as of March, Bank of America reports.
“The volumes are increasing,” says Corbett of Perritt Capital Management, which owns this stock. “Their business is substantially improving every quarter.” First quarter revenue grew 77.5% to $16.6 million, and net income advanced more than four-fold to $2.8 million. “The current economic landscape is proving favorable for our growth,” says CEO Ross Dove. “As we move through 2023, we expect to build upon the momentum demonstrated in the first quarter.”
5. Ribbon Communications (RBBN)
Buy limit: $3
Ribbon Communications sells communications equipment. Telecom giants are customers, which indicates that Ribbon markets competitive products. Verizon Communications for example, accounts for about 15% of the company’s revenue.
Three factors may boost the stock. First, growth in demand for bandwidth is being driven in part by more people working from home. Next, governments worldwide are banning equipment from China’s Huawei Technologies from national networks. “It opens up this huge market that has to be filled,” says Stoeffel, at Royce.
Finally, this is a turnaround story. “Turnarounds take longer than you think. We are now three years into it, and they are getting traction with customers,” Stoeffel says. The company reported a 7% increase in first quarter sales to $186.2 million. One other positive: Ribbon’s CEO, who has an excellent record here, recently purchased $1.35 million worth of stock at $2.60 a share. The nice size and the CEO’s record add up to a strong insider signal.
Michael Brush is a columnist for MarketWatch. At the time of publication, he had no positions in any stocks mentioned in this column. Brush has suggested TURN and RBBN in his stock newsletter, Brush Up on Stocks. Follow him on Twitter @mbrushstocks