In this week’s Validea Hot List newsletter, John Reese says that his Guru Strategy computer models are finding an array of values among small-cap stocks, particularly among those that would be considered small-cap growth firms. Reese’s Hot List portfolio added eight new stocks on his regularly scheduled rebalancing, all but one of which are in the small-cap growth category — one of the market’s most beaten-down areas of late.
For 2008, Reese notes, small-cap growth has been the second-worst performer among the nine size/style categories, according to Morningstar. Small-cap growth funds have lost almost 45 percent on average, with only mid-cap growth (-46.4 percent) faring worse. And during the past three wild months, small-cap growth has been the single worst of the style box categories, having lost an average of more than 33 percent.
But two factors have Reese excited about small-cap growth right now. First, that area of the market is getting a lot of interest from his guru-based computer models, with many of the Hot List stocks getting approval from three or even four strategies. Second, small-cap stocks have shown a tendency to produce impressive bounce-back gains coming off of bad periods. Says Reese, “Kiplinger’s Anne Kates-Smith noted last week that ‘stocks of small companies, particularly those growing at a good clip, historically have had the edge at the dawn of new bull markets, and many people think there’s a good case building for the little guys in 2009’. Since the Great Depression, Kates-Smith says, small-cap stocks have gained an average of more than 50 percent in the first year of bull markets.”
In addition, Reese says, small-cap stocks have also gained an average of 44 percent in years when the economy was flat or contracted up to two percentage points, according to Kates-Smith, who adds that P/E ratios on small- and mid-cap stocks are at their lowest levels in almost 20 years.
And in the end, that point about valuations is key, Reese says. “While we don’t know for sure whether small caps as a group will lead the next bull market, what we do know is that the stocks in the Hot List are all selling at tremendous valuations,” he writes, noting that the small-cap stocks in the Hot List are selling at very low price/earnings, price/earnings/growth, and price/sales ratios, even after a year of being in a recessionary climate. “Those are the kind of numbers that make these stocks incredibly attractive to disciplined investors over the long haul, and they make me quite optimistic about the Hot List moving forward,” Reese says.