Nervous that your stock portfolio’s performance depends on a handful of giant tech firms? Move over megacaps—“smidcaps” are about to shine. There is serious potential in investing in a blend of “small-cap” and “mid-cap” stocks. Smidcap investors benefit from scooping up small-sized companies with their faster earnings growth and relative anonymity, then holding these investments as they evolve into higher-quality, mid-sized firms offering more stable balance sheets and lower volatility.
Top fund manager Ryan Kelley, CFA, says smidcaps are in the stock market’s sweet spot this year after large-cap stocks have underperformed for a long stretch. Reasons: Smidcaps offer more attractive prices. The Russell 2500 index trades at valuations 22% cheaper than the S&P 500…and smidcaps may outperform the broad market in the conditions that Kelley expects in 2024 and 2025, including falling interest rates and a strengthening economy.
Bottom Line Personal asked Kelley how he selects smidcaps and which ones Hennessy Funds owns now…
Our process typically looks for stocks with market capitalizations ranging from $1 billion to $10 billion. Investing in companies smaller than that substantially increases volatility, and there’s less available research and analysis to draw on. Once a business rises above
$10 billion, it enters mid-cap territory and typically offers less opportunity for rapid growth. Three other criteria we use to choose smidcaps…
Look for solid performers in out-of-favor sectors. Sometimes a company is growing and has good fundamentals—but its stock price is depressed because investors are avoiding that particular market niche. If conditions in that sector or industry improve even a small amount, the stock price can take off. One of our funds is now invested in industrial manufacturers and engineering firms…energy-related companies such as refineries and oil-services…clothing retailers…and automotive-related businesses.
Focus on two metrics to find undervalued smidcaps. There are plenty of valuation measurements to analyze stocks, but price-to-sales ratio stands out for us because of its clarity. It’s simple to understand…hard to manipulate with creative accounting…and can be universally applied across any sector. To calculate the price-to-sales ratio, you divide the company’s market capitalization by its total revenue over the past 12 months. We like to see a price-to-sales ratio of less than 1.5, which often leads to bargain-priced companies that may be experiencing rough times but have unrecognized potential. To make sure the stock isn’t in a downward trajectory and has a promising tailwind behind it, we also look for price momentum. This includes annual earnings that are higher than the previous year and positive stock-price appreciation over the past three- and six-month periods.
Let your winners ride. Many small-cap investors take profits after a stock makes a big move up, but well-managed small-sized companies have the capacity to grow into mid-caps. We are disciplined about rebalancing our fund only once a year.
Market capitalizations of the following stocks range from $2 billion to $8 billion and meet the criteria above…
Fluor (FLR). The engineering firm provides procurement, construction and maintenance services in large-scale building projects for governments, as well as the energy, chemical and transportation sectors. The company has been hurt in recent years by cost overruns on fixed-price contracts as well as the speed and magnitude of inflation growth. But Fluor has a solid balance sheet and is well-positioned to benefit from more than a half-trillion dollars of infrastructure spending mandated by Congress. Recently, Fluor received one five-year contract to support the US Navy’s nuclear propulsion program and another to build the world’s first industrial-scale sodium-ion battery production facility in Sweden. Recent share price: $45.02.*
Gap (GPS) owns more than 2,600 retail stores under the brand names The Gap, Old Navy, Banana Republic and Athleta. The clothing retailer’s sales and profits have been declining for years due to competition from fast-fashion mega-chains such as H&M and the popularity of online shopping. But US consumer spending is likely to remain strong this year, and investors are overlooking several catalysts. Gap’s e-commerce accounted for 38% of total net sales last year, so the firm is becoming less dependent on indoor malls. Meanwhile, new CEO Richard Dickson—former president at Mattel, where he helped revitalize the Barbie brand—has been closing unprofitable stores and resuscitating Gap’s iconic brand names. Recent yield: 2.43%. Recent share price: $24.70.
Group 1 Automotive (GPI) operates nearly 500 automotive dealerships, franchises and collision centers, primarily in the southern US. It has taken time for inventory of new vehicles to reach pre-pandemic norms, so dealerships have struggled in recent years. Group 1 stock has one of the cheapest price-to-sales ratios in our portfolio. The company has plenty of opportunities to expand through acquisitions in its highly fragmented industry. Last year, acquisitions added $1.1 billion in acquired revenues. Investment in technology also has paid off for the company, including its digital platform, Acceleride, which allows customers to purchase and sell vehicles online…and VAL-U-Line, a brand that sells older, higher-mileage vehicles and offers a three-day/300-mile return policy and other benefits. Recent yield: 0.63%. Recent share price: $298.26.
Oceaneering International Inc. (OII) provides engineering services such as inspection and maintenance for the offshore oil-and-gas market. Its large fleet of 250 sub-sea vehicles carries out underwater repairs. The entire oil-services and engineering sector has languished due to the very high costs of deep-water drilling and major oil companies cutting back on capital spending. But recently, Oceaneering International won major contracts for projects in the Gulf of Mexico and the Black Sea. If war and geopolitics cause more oil-market dislocations and rising energy prices, investors will take notice of this stock. Recent share price: $22.02.
Oshkosh Corp. (OSK) is the world’s leading manufacturer for mission-critical specialty vehicles such as emergency vehicles for fire departments and airports and broadcast vehicles for TV stations. Investors have been wary because the company recently lost a $9 billion contract to build 20,000 tactical vehicles for the US Army, but a new US Postal Service contract to initially provide 60,000 electric mail-carrier vehicles should drive steady sales growth in the future. Recent yield: 1.71%. Recent share price: $107.55.
PBF Energy (PBF). The independent oil refiner has six facilities around the country that process as many as one million barrels per day to produce transportation fuels, heating oil, petrochemicals, feedstocks and lubricants. PBF was hit hard during the pandemic when demand for oil-related products dropped. The company cut its dividend and announced it would sell more than a half-billion dollars in assets. But business has rebounded…the dividend was reinstated…and PBF is nearly debt-free. Although oil prices have dropped from last year’s high of $90 a barrel, the refining business doesn’t depend as heavily on oil prices as exploration and production companies. Recently, PBF Energy opened a new plant in Louisiana that will produce 300 million gallons of biodiesel fuel annually. Renewable diesel fuel—made from plants, fats and animal waste—is a greener alternative for heavy commercial vehicles. Recent yield: 2.29%. Recent share price: $43.76.
