Small-Company Stocks Poised to Push Aside the Big Guys

Fund manager Christopher Beck isn’t interested in the stocks of fast-growing giants such as Google parent Alphabet Inc. and Amazon.com even though these companies have powered the nine-year bull market. He prefers less glamorous, small-cap companies that many investors can’t be bothered with, including a 1950s-style drive-in restaurant chain…a ­construction-equipment rental company…and a bank that focuses on Chinese-American customers.

Is that smart? Well, over the past decade, Beck’s portfolio of small-­capitalization value stocks—from companies that tend to have slow-­but-steady earnings growth and cheap valuations—have returned an annualized 10.1%, compared with 9.5% for the Standard & Poor’s 500 stock index. And he recently told Bottom Line Personal that this type of stock may become increasingly attractive. Here’s why and some examples of what Beck sees as the best companies in this category…

How (and Why) to Pick Small-Cap Winners

Stocks of large companies have done so well over the past decade that they have become richly valued and could fall harder than cheap small-caps if the overall market stumbles. We already have had some mini-examples of that this year. For March, the S&P 500 lost 2.54%…the Dow Jones Industrial Average fell 3.6%…and the small-cap Russell 2000 Index gained 1.3%.

Continuing danger: Unless you’ve been disciplined about rebalancing your stock portfolio over the past few years, you probably are carrying a lot more risk than you realize because soaring large-cap prices have skewed the portfolio toward large-cap stocks. By selling a portion of that asset class now and reinvesting in carefully selected small businesses, you can diversify—softening the blow if the market turns increasingly sour—without missing out if the bull market continues.

Small-caps have been largely out of favor since 2014, and it’s impossible to know when they will regain market leadership in a sustained way. But Beck sees specific catalysts for the companies his fund invests in to do well this year.

Lower corporate tax rates from the federal tax overhaul tend to benefit small banks, restaurant businesses and ­industrial-equipment companies more than their large multinational counterparts. That’s because the smaller companies typically generate more of their revenue domestically and pay higher tax rates. That means a more pronounced effect from the tax cuts on cash flow and earnings, which benefits their stock prices.

At the same time, small companies typically are better positioned to handle any continuing escalation in the trade wars that seem to be under way now between the US and China (and some other countries), arguably the most disruptive geopolitical risk to US and global markets in 2018. Domestic-focused US businesses should hold up better than those of behemoths that are dependent on overseas trade.

To take advantage of these conditions and find the best small-cap stocks, we take the following steps…

Follow the money. My team and I focus on investing in companies with sustainable free cash flow, which is the amount of cash left over after a company has paid all its expenses and made capital expenditures (money reinvested into the business). In my opinion, it’s the best gauge of financial health and greatest predictor of how well a stock can do. We also want to see management using this excess cash in shareholder-friendly ways, which could mean making regular dividend payments, buying back its stock and/or paying down debt.

Make sure the company has low debt levels and isn’t dependent on major capital spending to grow. When I began my investment career in 1981, the federal funds rate, which helps determine short-term interest rates, was a stratospheric 19%. During the 1981–1982 recession, I saw many companies with high levels of debt crippled by their interest payments. Rates are quite low today but have been rising—and they won’t always be this low.

Check for a strong balance sheet and attractive valuation measures such as a low price-to-earnings ratio (P/E) relative to the stock’s long-term history. We want to own businesses that can produce solid earnings growth year after year.

Six small-caps I have in my fund’s portfolio that meet the criteria above…

• Cheesecake Factory (CAKE). The chain of more than 200 casual-dining restaurants is known for its large portions and menu offerings. It attracts a more affluent customer base than competitors such as Olive Garden and Chili’s. Cheesecake Factory, which has little debt, has aggressively reduced expenses and become disciplined about opening new restaurants, all of which means that it has more money to give back to shareholders. Last August, its quarterly dividend was increased 21%. Recent yield: 2.3%.

• First Financial Bancorp (FFBC). This regional bank has branches throughout Ohio, Indiana and Kentucky. It’s a big beneficiary of lower corporate taxes. Also, higher interest rates on loans are allowing the bank to improve profit margins. First Financial, which has $9 billion in assets, also has been growing through acquisition, buying up weaker banks and specialty lenders in the Midwest. Recent yield: 2.6%.

• H&E Equipment Services (HEES) is one of the largest providers of heavy construction and industrial rental equipment in the US, including cranes, bulldozers and aerial-work platforms. It has offices in 22 states but is especially strong in the Gulf Coast and western US. The potential for federal government infrastructure spending could add to the company’s considerable free cash flow, and any possible tariffs on steel should not meaningfully impact the company’s business. Recent yield: 2.8%.

• International Speedway (ISCA) operates 13 of the country’s top motor-sports stadiums that host more than 100 racing events such as the Daytona 500 and the Talladega Superspeedway races. Fan loyalty to drivers, cars and tracks has spawned merchandising and advertising revenue and rising ticket prices for the company as well as an $8.2 billion, 10-year broadcasting deal with Fox and NBC to televise NASCAR races until 2024. The company is upgrading its facilities to attract a wider and younger audience. ISCA’s ticket sales have declined recently, but ticket sales make up less than 20% of revenue, and the company’s long-term broadcast deal should continue to prove lucrative. Recent yield: 1.2%.

• Sonic Corp. (SONC) serves more than three million customers each day at its Sonic Drive-Ins—kitschy, 1950s-style restaurants where waiters on ­roller skates serve customers in their cars. Sonic franchises about 95% of its 3,500 restaurants, which means that it has revenues from royalties as well as stable rent from the properties, which it typically owns. Locations are mostly in the South, but the company expects double-digit earnings growth over the next few years as it expands into the northern and western US. Recent yield: 2.4%.

• TTM Technologies (TTMI) is the largest printed circuit board (PCB) manufacturer in North America. PCBs are essential to connect complex electrical components in products ranging from smartphones and tablets to aerospace satellites and hospital MRI machines. Like many tech companies, TTM doesn’t pay a stock dividend, but it does have strong free cash flow, limited debt and a lucrative growth market in semiautonomous cars—it supplies PCBs for onboard ­automotive computers and digital environment sensors.

When Small-Caps Grow Up

When a small company succeeds and its market capitalization grows into the mid-cap space, we don’t necessarily sell the stock at a certain market cap cutoff—in fact, we even might buy more shares. Typically, it is a company’s reduced ability to generate free cash flow or deterioration in the quality of a company’s balance sheet—which may come as a result of macroeconomic events, industry changes or management actions—that will cause us to sell a holding. Those are our main concerns. If we no longer believe that a company has the ability to resolve fundamental issues, we will get out. We also may identify a name in a sector that provides a more attractive risk-return profile than something we currently own. One example of a stock that we bought as a small-cap but we continue to own as a mid-cap…

East West Bancorp (EWBC). This bank, founded in 1973 to meet the financial needs of Chinese Americans, is the largest holding in the fund’s portfolio. With $37 billion in assets and 130 branches, East West is now in seven states—California, Georgia, Massachusetts, Nevada, New York, Texas and Washington. It offers better profitability than its competitors and a rising dividend. Market cap: $8.9 billion. Recent yield: 1.3%.