Why Small-Cap Value Stocks May Be Poised to Outrun the Market
As expected, the Federal Reserve lowered lending rates by 0.25% yesterday and indicated further rate cuts this year and next.
Fed Chair Powell also admitted that while “inflation remains elevated… labor demand has softened.” He went on to say that the pace of job creation is now running below the rate needed to keep unemployment from rising.
So, in a nutshell, there was a little something for everyone in the Fed’s recent deliberations – a nod to both inflation hawks and for those concerned about the economy’s health.
At the end of the day, the projected path for interest rates didn’t change all that much, but it’s definitely pointing to lower rates – potentially as low as sub-3% by the end of next year.
And as I detailed in my last column, changes in the interest rate cycle often have a habit of bringing about shifts in stock market leadership too.
As shown in the chart below, stocks generally perform better with falling interest rates than in a rising rate environment. But the biggest beneficiaries tend to be value stocks, especially small-cap value.
In fact, investors have already anticipated the coming rate cuts, with the Russell 2000 Index of small-cap stocks outperforming the S&P 500 of large-cap stocks in recent months.
And for my money, this shift in market leadership is just getting started – with plenty of room to run further.
A good way to take advantage is by prospecting for new investment ideas using the market-beating TradeSmith Value strategy, as I detailed on Tuesday.
But we provide multiple tools on the TradeSmith Finance platform to get the job done. And another great way to prospect for small-cap value stocks is to simply build your own screener in a few easy steps.
Shortcut to Small-Cap Value Stocks
From your TradeSmith account, click on Invest, then on Screener. Next, simply select + Add Filters to begin building your screener. Here’s how to do it with just six essential filters.
Here’s why these filters matter:
- Health: As always, start with healthy stocks in the health indicator Green or Yellow zones, just as our Value strategy does.
- Business Quality Score (BQS): Quality is key when it comes to value investing to avoid value-trap stocks. So, I limit my search to stocks in the top half of our quality ratings.
- Free Cash Flow Yield (FCFY): Another measure of quality and pricing power, I insist on stocks with 3% or more, above the market average.
- Markets: Let’s also limit our screener to small-cap stocks in the S&P Small Cap 600 (SML) and Russell 2000 Index.
- Price/Earnings (P/E) Ratio: With the market average at 22X today, so let’s prospect for stocks with below average P/E valuation.
- Price/Book (P/B) Ratio: Likewise, the average P/B for stocks today is 3X, so let’s screen out any stocks with above average P/B ratios.
When I ran this screen, I got 76 results, with the top 10 shown below – plenty of stocks to prospect for new ideas with some additional research.
I sorted my results by Health, so stocks at the top had most recently entered the Green zone. But you could just as easily sort by Business Quality or Free Cash Flow Yield.
You could also narrow your results if you wish by tightening up the valuation parameters. For instance, I adjusted my screen by lowering the valuation ratios to a P/E of 15x and P/B of 2X – and got just 38 results.
You could also adjust the parameters Free Cash Flow Yield and Business Quality Score metrics.
To cast a wider net with more results, simply widen the valuation ratios a bit or you can also add more Markets, like the S&P 500. Large-cap value stocks also tend to outperform amid falling rates.
Mike Burnick’s Bottom Line: Historically, value stocks shine as interest rates decline. You can take advantage of this with our TradeSmith Value strategy to find all stocks (of any size) that meet all our strategy conditions. Or, build and save your own small-cap value screener to either narrow or widen your search for potential winning stocks.
Good investing,
Mike Burnick
Senior Analyst, TradeSmith
P.S. While falling rates may set the stage for small-cap value stocks, there’s an even bigger story unfolding across the entire market.
TradeSmith’s Melt-Up Quotient – a rare signal that’s only appeared twice in 125 years – has triggered again. The last time this happened, it sent stocks like Microsoft, Dell, and Cisco soaring 1,000% or more.
Oracle’s nearly 40% surge is just one early example, and our research shows it could only be the beginning.
That’s why TradeSmith’s CEO, Keith Kaplan, has released a special online briefing. He explains the rare “Mega-Melt-Up” now underway, shares the data behind this powerful signal, and reveals 10 stocks currently flashing green zone buy signals that could lead the charge.