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How to Profit from the Big Shift to Small-Cap Stocks

Date: December 1, 2016      Publication: Bottom Line Personal      Source:  William Costello, CFA, Westwood Holdings Group      Print:

William Costello says it’s time to get small. The fund manager points out that for nearly the entire length of the seven-year-old bull market, stocks of well-known big companies have dominated…but this year, small-company stocks have started to sizzle. They returned 8.8% this year through October 31 as measured by the Standard & Poor’s SmallCap 600 index, nearly three percentage points more than the S&P 500, a large-cap index. Costello says that the shift is likely to continue for years. Historically, large-caps and small-caps take turns leading the market, and each stretch of ­outperformance typically lasts several years.

Even when small-caps are not leading the market in general, Costello has had a knack for picking small companies with big potential that most investors have never heard of. Over the past five years, the fund he manages—Westwood SmallCap Value—had an annualized return of 14.7%, beating the S&P 500 by one percentage point a year.

Bottom Line Personal asked Costello why small-cap stocks are taking the lead, how he selects the best ones and which ones he finds most attractive now…

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OVERLOOKED SMALL-CAPS

Even if the US economy remains healthy and grows steadily, many stocks have limited potential for gains at this point. They are either too expensive or they depend on revenue from exports, which have been hurt by weak foreign economies and the strong US dollar. The companies that I focus on, with market capitalizations from $500 million to around $1.5 ­billion, suffer neither of these headwinds. Their revenues come almost exclusively from US customers.

The stocks also tend to be undervalued because most Wall Street analysts don’t bother to cover them and small investors gravitate toward high-profile stocks that they recognize, such as Amazon and Facebook.

Here are the characteristics I focus on in “overlooked” small-caps…

Strong balance sheets and manageable debt. I’m not interested in risky, speculative stocks. The companies I invest in are long-term, sustainable businesses.

Strong free cash flow. This enables companies to self-finance their growth, which means that they won’t have to borrow more money as interest rates rise.

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Clear catalyst that allows them to grow their earnings for many years. A winning new product or service can quickly double or triple annual revenue for a small firm, whereas it may not even move the needle for a company in the S&P 500.

MY FAVORITE NOW

Adding the stocks of one or more of these small companies to a predominantly large-cap portfolio can help boost long-term returns and provide diversification. Each of them fits the criteria described earlier…

  • Heartland Express (HTLD), one of the largest truckload carriers in the US, is benefiting from continued improvement in the domestic economy. The company ships appliances, automotive parts, ­paper products and packaged food, among other items. It dominates its niche, the short-to-medium-haul market of less than 500 miles. And these shorter hauls insulate the company from competition from railroads. Heartland’s shipping lanes have traditionally served customers east of the Rocky Mountains. But its $300 million acquisition three years ago of ­Gordon Trucking, a West Coast competitor, allowed Heartland Express to push into the western half of the country. Earnings will likely grow an average of 10% a year over the next five years.
  • International Speedway (ISCA). This company operates 13 motorsports stadiums that host more than 100 events during the racing season, including the famed Daytona 500 and the ­Talladega Superspeedway races. No competitor comes close to matching its dominance in the sport through admissions, merchandising and advertising deals. International Speedway can expect hefty guaranteed revenues for the next ­decade, thanks to an $8.2 billion, 10-year ­NASCAR television contract that it signed last year. It also should see higher merchandising revenue after completing a $400 million renovation of the Daytona International Speedway that more than tripled concession stands and added luxury suites.
  • LegacyTexas Financial Group (LTXB). The share price for this regional bank with more than $8 billion in assets has been hurt by fears of massive loan defaults from overleveraged ­energy companies. Oil prices still are half what they were in early 2014. However, LegacyTexas is in much better financial shape than investors realize. Most of the financial malaise in energy loans has hit Houston and southern and western Texas, not the robust Dallas region where LegacyTexas operates. In fact, if North Texas were its own state, it would rank as the ninth-largest economy in the country. Loan growth at LegacyTexas continues to top 10% annually. Higher interest rates expected over the next year should help improve profit margins.
  • OmniCell (OMCL). Medical-­supply management isn’t the sexy part of health care. But this company addresses a critical problem for hospitals—making sure that the right drugs and dosages get to patients, traditionally a manual process prone to errors. OmniCell makes software and automated dispensers that allow major health-care facilities such as Johns Hopkins Hospital and Massachusetts General Hospital to manage and deliver medications safely and efficiently and to bill for them accurately as they move from the pharmacy to the cart on the nurse’s floor to the patient’s bedside. Only 10% of health-care ­facilities have such technology in place thus far.
  • Oxford Industries (OXM). This apparel company specializes in upscale beach and resort wear. Its flagship clothing brand, Tommy Bahama, has suffered from flat sales in the past few years, which has depressed Oxford’s stock price. But investors have largely overlooked the company’s next rising star, Lilly Pulitzer, a line of affordable, brightly printed women’s wear, children’s wear and home goods sold in about 30 stand-alone stores, mostly in the eastern US. Currently, the line accounts for 20% of Oxford’s sales. But a test of a discounted Lilly Pulitzer line in Target stores last year was extremely successful, quickly selling out and showing great potential for Lilly Pulitzer sales. Now Oxford plans to quadruple the number of Lilly Pulitzer stores.
  • Synergy Resources (SYRG). Investors are wary of small energy companies engaged in hydraulic fracturing, or “fracking,” with good reason. Despite the surge in oil prices in 2016, prices haven’t risen high enough for many of the companies to be profitable. Synergy is an exception. It is ramping up production at its 96 wells on 90,000 acres in Colorado. With a solid balance sheet and little debt, it is one of the best-positioned frackers, even with oil prices in the recent range of $40 to $50 per barrel. I don’t expect oil prices to collapse again, given reasonably strong global oil demand and limited growth in non-OPEC oil supplies. And Synergy can be highly profitable now because the Denver–Julesberg Basin in which it operates is one of the lowest-cost areas in the US to drill. Synergy also should benefit now that state proposals to limit drilling and allow local governments to ban fracking in Colorado have failed to attract enough signatures to qualify for a statewide ballot vote.
  • Trex Co. (TREX), a leading manufacturer of plastic-composite decking that is more durable and costs less over time than wood, is the top holding in my portfolio. Trex has made a stunning turnaround from a decade ago, when quality lapses and consumer lawsuits nearly bankrupted the company. It now controls 40% of the nonwood decking market in the US, and the industry has strong growth potential. There are 40 million wood decks around the country, and all of them are slowly or quickly ­decaying. The company maintains a cost advantage over rivals because of a new proprietary manufacturing process that combines waste-wood fibers with more than 400 million pounds of recycled plastics annually.

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Source: William Costello, CFA, senior vice president at Westwood Holdings Group, Dallas, which manages $21 billion in assets. He is comanager of the Westwood SmallCap Value Fund (WHGSX). Over the past five years, it has outperformed 98% of funds in its category. ­WestwoodGroup.com