Barron's Streetwise - 6 Small Cap Stock Picks

Episode Date: July 28, 2023

The case for pint-size companies, plus top ideas from growth and value managers. Learn more about your ad choices. Visit megaphone.fm/adchoices

Calling all sellers, Salesforce is hiring account executives to join us on the cutting edge of technology. Here, innovation isn't a buzzword. It's a way of life. You'll be solving customer challenges faster with agents, winning with purpose, and showing the world what AI was meant to be. Let's create the agent-first future together. Head to salesforce.com slash careers to learn more. The worst five-year rolling period for Russell 2000 as compared to the S&P 500 since 2000, small caps went on to outperform large caps

by nearly 50% over the following five years. So history would suggest that this level of underperformance typically mean reverts. Hello and welcome to the Barron Streetwise podcast. I'm Jack Howe, and the voice you just heard is Brad Newman. He's the director of market strategy at Alger, and he's going to tell us why small cap stocks look attractive now. And he and another money manager will tell us about a few of their favorite small cap stocks, from e-commerce price optimization to slushies to ball bearings.

Those are different companies. It'd be a pretty weird conglomerate if they weren't. I don't know what the case would be for synergies. Is this still the intro, Meta, or have we started? We're actually at the end now. You can just do the outro. Thank you for listening. Meta Lutsoft, our audio producer, is listening in as always.

Hi, Meta. Hi. Should I talk about my weekend trip to Dave & Buster's or get right to small caps? Don't answer that. I know you're waiting to hear about Dave and Buster's. Have you ever been? No, I haven't. This is my second trip this summer. I mean, I haven't been to Dave and Buster's regular, but what happens is you go in, you got to get this game card. And then if you leave before the card is done, now you got to go go back. Then you put a little more in the card because you don't have quite enough. It's a whole thing. You spend twice as much as you would normally spend at a restaurant,

but the kids get to play games and run around, and it's fun. That's a publicly traded company. The ticker is Play. And it caught my eye because the stock in the day of the most recent earnings report, it jumped 18%. That's how I judge an upside surprise. I don't look at whether a company beat Wall Street estimates because that's more about whether Wall Street did a good job of estimating. I look at what the stock did. And this stock indicated to me that people were surprised to the upside by quite a bit. The stock has not been a great long-term performer. This year, it's outperforming by more than 10 points year to date,

and the S&P 500 is having quite a year on its own. So something is going right. Here's a recent Raymond James note. They talk about the company refinancing some debt, getting a better deal on its debt. That's always a good sign. And the note reads, we are optimistic that management's multi-pronged revitalization and growth plan can drive strong EBITDA growth over the next few years, which should allow the stock to outperform from still depressed levels.

How depressed? It goes for less than 13 times forward earnings estimates. I know you're waiting to bring this around to tuna, so you might as well just. I know you're waiting to bring this around to tuna, so you might as well just... Look, I already talked about how I've been watching some back episodes of Wicked Tuna, and I don't want to make this a thing. I can't keep going on about this. But I just will point out that when I was at the restaurant, the boy took off with his card. He was very excited to play, and he kept coming over and said,

Dad, you've got to see, I got 100 points. I got 1,000 points. I was peeking over, but I was working on my hamburger. And so I was, you know, I was half paying attention. Then my daughter comes and she says, there's something I think you should see over here. You're really going to want to see this. And she brought me over. And there's a game.

It's called Wicked Tuna. And it's got rods and reels. And four people can play at the same time. And you can choose your favorite boat. You can be the hard merchandise. You could choose your captain and you cast out there and you reel it in. And, you know, so I got to go back when the kids aren't around and drop some extra cash. I'm not saying that's what's driving the stock this year. I don't think that's probably a big part of the thesis, but it seemed to be doing all right. And I had written off the

food and video games combination as a good business for investors, but let's wait and see what happens. Something's percolating with this stock. Now that's a $2 billion company. I would call that a small cap. There's no real clear definition of how small is small and how midsize is midsize because the value of the market goes up over time and takes the value of companies with it. So that's a constantly shifting number. But a couple billion dollars, that's a small cap to me. And that stock is not a pick from either of the money managers we'll be hearing about in a moment. It's just something I'm ranting about. But I did see a report about small caps from Alger,

the money management company that caught my eye. And it says that small caps have really lagged way behind large caps. We've talked about how the S&P 500 is way up and how performance is being driven by a handful of tech giants and about how the index looks expensive. And that's pretty much because these seven giant tech companies are themselves ambitiously priced relative to earnings. We also talk about there's kind of a meme stock grab or it's really shares of lower quality, heavily shorted companies that people are getting excited about in chat rooms and going after their shares. And some of those most dubious companies while skipping right over mid-caps and small caps, which are well-established companies that are plenty profitable. And I'm not sure why there hasn't been a small cap rally. The note from Alger makes the case that the last time small caps underperformed large caps by this much was two decades ago.

And after it happened, small caps went on a tear for the next five years. That is, I guess, mean reversion. Some things on Wall Street tend to get out of whack for only so long before they have to move back into whack. You need a whack reversal is what I'm saying. Here's the thing. I have no idea whether now is the moment for small caps. We've said that in the past. We've talked about small caps in the past. I don't know when the moment is going to come when people embrace these stocks. I don't know why they haven't yet.

But if you're looking at your S&P 500 fund and you're thinking things are looking pricey right now, the market's way up, maybe it's time to diversify into some small caps. And so I wanted to talk more about that. And here's some picks because I think of the small cap stock universe as being a picky place. That's not the right word. Not picky as in fussy. A place that favors stock pickers. We're going to hear about that in a moment. Here's my conversation with Brad at Alger. What's going on with small caps? How do they look relative to large caps? Are they especially cheap right now? How do they look on valuation? Small caps are hated, and their performance and their valuation reflects the fact that

they are hated. We just actually did a survey with our clients, and what we found was that professional investors who were on this call that we did, 84% of them say small cap performance will improve or perform in line with large caps over the next few years or reversing a trend. But those same professional investors, 87% are equal weight or underweight small caps. So they think they're going to begin to outperform, but they're underweight them. I look at the stock market and I see it's done very well this year. It's been led by some tech giants. But lately, in recent weeks, we've seen people call it the return of meme stocks. There are companies out there, maybe it's in crypto mining, maybe it's in some companies that haven't

really been profitable. I think to myself, here's this whole class of the stock market, small companies, where you've got profitable companies with long track records. Investors seem to be skipping right to la-la land instead of just looking at the smaller companies. What do you think it is about small companies that people just don't want to dip into them right now? Well, I think a lot of the news this year has been about innovation and artificial intelligence. And the playbook for artificial intelligence has been large cap companies that

are in the news, your NVIDIA's, Microsoft's, etc. And they certainly capture the media headlines with respect to chat GPT and other artificial innovations. But a lot of small cap companies, and I have some for you, are leveraging artificial intelligence. They're just not getting the media headlines. And so their earnings and their sales and fundamentals are doing quite well, but they're not capturing the attention of the average investor. And so their stocks are languishing and the valuations are becoming quite compelling to large caps. So if you're someone who you're looking at your S&P 500 fund and you say, on the whole, the market looks expensive relative to earnings, maybe not all of its stocks, but

the index looks expensive. And you're saying, I want to get maybe some smaller companies in order to average my valuations down. Should you have reason to believe as an investor that their day will come for small caps? Will they come around? Does there have to be a catalyst for that? How does it typically play out? What has happened in past cycles like this? Well, all you can say about valuations is that when they're on your side, they provide a tailwind for performance probably at some point if the fundamentals are good as well, but you can't say exactly when. So I don't have a catalyst for you, but I will say the last time that small cap stocks underperformed large caps by such an extent. So this is the worst five-year

rolling period for Russell 2000 as compared to the S&P 500 since 2000. The last time it was this bad in 2000, small caps went on to outperform large caps by nearly 50% over the following five years. So history would suggest that this level of underperformance typically mean reverts. And the same can be said for valuations. Small cap stocks typically trade at a premium to large cap stocks because small companies grow faster. So obviously investors like fast growth and they typically pay a premium. But today, the S&P 600 small cap index is trading a 28% discount to the S&P 500. Are there any examples of companies where you said, I really like that company, but

this one thing that they have is just a deal breaker. We don't like to see that attribute in any of our companies. Is there anything that you just walk away from when you see it? We really don't like a company that could be on the wrong end of how an industry is evolving. So in other words, a company could look fantastic on paper, could have strong margins, could even be growing nicely, could have a management team that's well-respected. But if we think, I'm just going to make this up, say they're an enterprise software provider and they haven't fully made the transition to cloud computing, and we believe that most software will be software as a service on the cloud. If we don't believe that they can make

that leap, then even if they have a strong business now, then they may not have a strong business in the future. So we need to be able to see that they're evolving to where the industry is going, or even better, that they are leading the industry to where it's going. Could I ask you to share with us three stocks that you really like right now? Yeah. So one of the stocks is Proz Holdings, ticker PRO. It's a $33 stock or so as we're talking about $1.6 billion market cap. And they do pricing and revenue management software. You know how when you go on to buy an airline ticket and notoriously the price changes every second and you think they're watching you because they know what you clicked and then all of a sudden the price is

higher. Proz was really the leader, early leader in figuring out how to dynamically adjust pricing in the travel space. And now there is the potential for them to really roll that out to just a variety of industries. You can imagine the day in the future where Amazon's prices are dynamically changing all the time based on a customer's willingness to pay. And so this is a company that's been using artificial intelligence software for years and years and years to figure out correct predictions of customers' willingness to pay so they can help guide companies to get the most out of their pricing and their business. In fact, they recently had an analyst day and they highlighted

that their study showed that the value that they add is so tremendous that the average customer sees an 8% revenue lift and a 200 basis point margin improvement. And all that results in a nine-month payback on this software or a 400% return on investment in three years. That's a lot of what Alger is looking for. Does the company that we're looking at provide a product or service that adds a lot of value to its customers? If it does, it's going to be in demand. So funny that you mentioned that. I put something in my Amazon cart a week or two ago. The price went up before I checked out. And I thought, you know what? I'm going to drop this out of my cart. I'm going to play hard to get here. I'm going to make Amazon think that I don't really need this thing. I gonna play it cool i'm gonna see if the price

goes down hasn't worked yet i'm waiting we'll see who wins this battle be around they're on to you they know that you're searching somewhere else all right what else that's uh that's an interesting one and that's new to me thank you what else do you like this other one that is also kind of in the travel-ish industry uh it's called rbc bearing, stickers RBC, over $200 a share. It's a $6.5 billion market cap. They are a precision manufacturer of ball bearings. So ball bearings are the things that help objects rotate. And so they make these components for the aerospace industry and industrial markets. So as the aerospace industry grows and comes back from COVID, I think they stand to benefit. They were the Boeing supplier of the year out of 13,000

suppliers to Boeing. We think they have a really strong competitive advantage because they have long-term contracts. They have high market share in the parts they supply. I'm looking at the margins as you speak in this company, and they're pretty darn healthy. I think of ball bearings as being just metal balls. I mean, there must be more to it than that for this company to be as profitable as it is. Yeah, well, think about the military and getting a ball bearing designed for the military. It's a long approval process. The military isn't going to switch on a dime or, you know, same thing for Boeing. And that gives them really high margins, nearly 30% EBITDA margin.

They've been free cash flow positive. I think in every year they've been public. So it's a good business because they're good at what they do. Is there a third one? Yep. And the third one comes back a little bit to the AI piece and software piece. In fact, I pitched it on your show in the past. It's Guidewire Software.

It's about a $78 stock, $6.7 billion market cap. They provide software to the property and casualty insurance market, transaction processing, data management, analytic solutions. They have been in the midst of transitioning from on-premise software to cloud-based software. from on-premise software to cloud-based software. That is now more than half the business. They are, we think, really valuable to their customers because they know their customers so well. In other words, they just provide software in this one vertical. We think it's about a $16 billion total addressable market.

So this is the kind of software that can help an insurer figure out where to price a policy at just the right level to be competitive against other insurers, but not to sell it too cheaply. Is that the idea? Yeah, it's partly underwriting, but it's also just kind of the back office nuts and bolts with claim servicing and billing and stuff like that, because they know how these businesses work so well. How do you feel about the market in general going forward right now? For someone who's putting money to work for the next five or 10 years, are you reasonably optimistic about the growth we're going to see in the economy or the returns we're going to get from

stocks and bonds? Are there any potential trouble spots that you see on the horizon? from stocks and bonds. Are there any potential trouble spots that you see on the horizon? Well, I think it's a bit of a nerve wracking time for the overall large cap indices that a lot of your listeners may be looking at. The valuations are relatively high compared to history. The monetary tightening has maybe not worked its way

all the way through to the economy. So the economy may still be in a softening pattern, yet the valuation is relatively high. We have the money supply declining for the first time since the 1930s. And so I don't think that the risk reward is fantastic for the year term for large caps, but I do think for small caps, it looks much better in part because of the underperformance and valuation that we spoke about earlier. Thank you, Brad. Alger is a company that's known for its growth stock funds. Coming up after this quick break, we'll hear from a value manager with three more small cap picks. Welcome back. Meta, a minute ago, we talking about microcaps, which are companies that are smaller than small.

I saw one definition online, and it's pretty arbitrary, but it says companies valued at between $50 million and $300 million. And you asked what? What's smaller than a microcap? What? What's smaller than a micro cap? Which I think is a great question because if you can have something smaller than small, why can't you have something smaller than micro? I haven't heard of anything before, but you know what?

I guess it's got to be a nano cap. And I think the reason I haven't heard that before is because there are not a lot of companies out there that are worth less than $50 million that are trying to raise capital from the public by issuing shares. But there have to be some companies that started in small or micro territory and things didn't go their way and then they slipped to sub-micro. Maybe we should launch a nano-cap fund. Right. We just need, you know, 50 bucks from three people. bucks from three people. Let's hear some more small cap stock picks, this time value stocks. I spoke recently with Brian Van Cronkite. He's Senior Global Equity Portfolio Manager at All Spring Global Investments. Brian was explaining to me his process for finding good stocks and it involves

looking for cases where investors have overreacted to something like earnings news and they're missing more positive clues in a company's balance sheet. We have to be honest with ourselves that the markets are relatively efficient. And if that's the case, the only way for us to create excess value to justify our existence as active managers is to find some market inefficiency and exploit it. And the reality is most of academia is focused on helping people understand income statements and what that means for the value of business. But what drives the income statement? In our mind, what drives that is the balance sheet. But the balance sheet doesn't lend itself nicely to backward looking extrapolation. It doesn't lend itself nicely to quant metrics that can be utilized to predict the future.

It takes a lot of work to understand how a management team thinks about their optimal capital structure and how they think about using that over time. And so we try to understand that at a pretty intimate level. And then as you watch them deploy capital, they're frequently surprising the market. They're surprising it as they report organic sales above expectations or margin expansion beyond people's hopes. And that's then when the market reacts to it. But if you have to trace that back to the balance sheet, if you want to understand it ahead of time. Can you tell me about a few of the stocks you like? One of our consumer staples that we like is a company called J&J Snack Foods. I think many people have actually tried their products, but don't know that those products

belong to J&J Snack Foods. They tend to sell through the event spaces. So think movie theaters, big stadiums. They own the large pretzel brands, the Icy brand, Luigi's Frozen Ice. They most recently acquired the Dip and Dots brand. My 11-year-old and 8-year-old can't leave any stadium without having at least one Dippin' Dots before heading home. So the pandemic was very challenging to them. If you think about just the lack of people going to big events, whether it's ball games and movie theaters, it had a major dent in their revenue streams. On top of that,

the supply chain challenges that many companies face, they also face that. So they had demand destruction on the top line. They had inflation on the cost of goods sold line, put tremendous pressure on their earnings and free cash flow. What we see today, though, is obviously the recovery of demand, but also a management team that's been working behind the scenes to optimize their manufacturing footprint and raise prices. And as all that comes together in the quarters and years ahead, we think there's a tremendous amount of opportunity for this company to demonstrate that they've been able to take advantage of an otherwise challenging time period. I'm looking at the company, the ticker is JJSF, and the brands include Icy and Slush Puppy. You said Luigi's, also Minute Maid. I can't remember

what a Dippin' Dots is. Help me out. That's not the ice cream one, right? Little balls of ice cream? They're little balls of ice cream that are frozen. You can get them in these little tubs. And I don't know why, but apparently they taste better than the ice cream itself when you put it in a ball shape. And so I charge a nice premium for that. All right. Well, that's a company I can get my head around.

What else do you like? In the industrial space, we like a company called Air Lease, ticker AL. We like this business because there's been tremendous consolidation in the airplane leasing business. Obviously, another industry destroyed by the pandemic in many respects. As airlines across the globe were collapsing, they had to face some serious balance sheet driven challenges. And what are they going to do with their assets? And what are they going to do with navigating an area where they're getting zero revenue, basically. And what we like about this space is that the highest priority asset for this industry is the airplane. If you're anything from a Delta flying people or a

shipping company flying boxes, if you don't have a plane, you have no business. And so it's one of your top priorities to pay your leases and to make sure you have a fleet that operates well. And so during the pandemic, AirCap, now the largest air leaser in the industry, bought the air leasing business from GE. And that consolidation drove a meaningful change in pricing power on top of a shift in demand as companies no longer can buy their planes, they need to lease more planes. So we see growing demand on this side of the pandemic. We see better pricing power for the industry that's now consolidated.

This sounds kind of like a middleman role. So why is it that the airlines like to deal with this sort of middleman type of company here? What is it that they gain from doing business that way? Part of it's the inability to actually have the capital to buy every single asset. These are expensive planes. It's very challenging to put all that on your balance sheet and pay all that capital up front or to finance it in different ways. So the airplane leasing business provides flexibility to their customer base, and that's a value add component for their customers. Now, one other thing that we think is maybe misunderstood or underappreciated is just

how challenging it is to get your hands on a new plane nowadays. If you're a big shipping company, for example, and you need a handful of new planes, you're going to be getting in line maybe two, three years later. The biggest buyers of airplanes from Boeing and Airbus are these airplane leasing businesses. So they're oftentimes first in line and have the best prices. Okay, great. So that's two stocks. Do you have a third that you like? Sure. The name we like, it's a little bit larger. It's in the upper end of the small cap space, a company called Euronet, ticker is E-E-F-T. Another business that people likely don't know they use on a very regular basis. Euronet is in three businesses. One of them is Money Transfer. They're the competitor to Western Union. They do it with a technology that is far more efficient, and therefore they provide

money transfer business at a much cheaper rate than Western Union. They also are digital, native digital, if you will. The second business they do is an ATM business. Most of this is throughout Europe, but it's quickly expanding to other countries. And this business is all about moving money around and having a digital technological backbone that they can leverage to do that. And the third business is dynamic currency conversion. So when someone goes from one country to another country and they use their credit card as the option to convert that currency and they provide those services, which are nice high margin services. These businesses, again, negatively impacted by the pandemic. But this management team has maintained their aggressive tilt towards allocating capital, a lot of it organically through R&D, constantly working on technology to advance the way they can create and process transactions.

processing for things like credit cards or in-game transactions, anything that goes through any digital transaction they can help process. So it's all about volume and taking a very, very small piece of the overall price on every transaction that takes place across all their businesses. And they're growing aggressively, taking share from competitors who are struggling and shutting down. And so this business we think has a very, very robust growth opportunity ahead of them, most of it organic. But today, the market still focuses on just a small sliver that's tied to tourism. We have the markets mispricing that dynamic today. Thank you, Brian and Brad and Dave and Buster. If you have a question you'd like answered on

the podcast, just tape it on your phone. Use the voice memo app. You can send it to jack.how. That's H-O-U-G-H at barons.com. Thank you for listening. Meta Lutzoft is our producer. Jack, we need a name for our nano fund. Tiny Advisors Capital. People are going to think the advisors are tiny. Tiny Stock. I got to work on it. Subscribe to the podcast on Apple Podcasts, Spotify, or wherever you listen to podcasts. If you listen on Apple, please write us a review. See you next week.