Small-cap stocks are the hottest investment cluster in the current market environment, with their index outperforming the large-cap brethren by wide margins.
This is especially true as the Russell 2000 index outpaced for three straight months through May, representing its longest winning streak in almost two years. Another index tracking the small-cap stocks, the S&P Small Cap 600 has also beaten the S&P 500 by a wide 9.5% — a three-month premium level not seen since May 2002 — according to data from S&P Dow Jones Indices.
In fact, all the 11 small-cap sectors turned strongly positive in May from a negative showing in February. This quick rebound is the ninth in history since January 1995 when the small-cap sectors went from all losing to all winning in three months or less.
Below we discuss some strong reasons for the outstanding performance of the small-cap space and their continued outperformance.
Small-cap stocks are the biggest beneficiaries of the tax cut as stocks on the Russell 2000 pay higher taxes with a median effective tax rate of 31.9%. In comparison, the larger, multi-national companies on the S&P 500 pay a lower median effective tax rate of 28%, while the tax rate for 30 mega-cap stocks on the Dow Jones Industrial Average is even low at 23.8%.
As the pint-sized stocks are closely tied to the U.S. economy and do not have much exposure to the international market, an encouraging domestic economic trend backs their momentum. The U.S. economy has been on roll and entered its second-longest expansion phase since 1785. It regained momentum in May as depicted by the slew of upbeat numbers after a slowdown in the first quarter.
After two months of lackluster gains, hiring in the United States rebounded with the addition of more-than-expected 223,000 jobs in May. The unemployment dropped from 3.9% to 3.8%, the lowest since 2000 while average hourly wages rose 8 cents, pushing the year-over-year increase to 2.7%. Manufacturing activity expanded at a faster pace than expected, indicating that American manufacturing is enjoying a 21-month winning streak. Meanwhile, data from the Commerce Department shows that the construction spending rose 1.8% in April -- the largest increase since January 2016, after a 1.7% decline in March.
Consumer spending, which accounts for more than two-thirds of U.S. economic activity, surged the most in five months by 0.6% in April while consumer confidence rebounded near the 18-year high in May. So clearly, all the latest data points signal good times for the domestic economy.
Further, the massive $1.5-trillion tax cut will perk up the economy and save billions for corporations, boosting job growth and earnings.
Politics and Geopolitics
Global sentiments have been deteriorating due to U.S.-China trade talks, Trump’s decision to re-impose sanctions on Iran and Venezuela, and now the initiation of steel and import tariffs on America’s biggest allies — the European Union, Canada and Mexico — which were previously exempted from the duties, since these were announced in March.
All these developments could trigger a global slowdown and roil the broad stock market, weighing on large-cap stocks but benefiting the small caps. These are less prone to these events and well insulated from international headwinds. The pint-sized stocks are considered safe and better plays if political issue or economic turmoil creeps into the picture.
Apart from these, strength in the U.S. dollar is providing an additional boost to these stocks.
Per the latest Earnings Trends report, earnings from 94.3% of the S&P 600 index capitalization are up 25.2% on 9.4% higher revenues, with 55.6% beating EPS estimates and 72.1% beating revenue estimates. Earnings and revenue growth as well as revenue surprises are notably tracking above historical periods for the small caps. For the quarter as a whole, total S&P 600 earnings are expected to be up 20.7% on 9% higher revenues. The rising earnings trend is likely to continue for the next two quarters, with an expected growth rate of 29.2% in the second and 34.5% in the third.
Stocks to Tap
In view of the reasons discussed above, we strongly believe that investors should consider small-cap stocks that have high growth potential as well as strong momentum. Below we have highlighted five of them that have a Zacks Rank #1 (Strong Buy) or 2 (Buy), a Growth Score of A, a Momentum Score of A, and an industry rank in the top 45%.
Based in Mobile, AL, Computer Programs and Systems Inc. (CPSI - Free Report) provides healthcare information technology solutions and services in the United States and the Caribbean nation of St. Maarten. It saw solid earnings estimate revision of 25 cents over the past three months for this year with an expected earnings growth of 31.07%. The stock has a Zacks Rank #1 and belongs to a top-ranked Zacks industry (top 25%). You can see the complete list of today’s Zacks #1 Rank stocks here.
Based in Norwood, MA, Xcerra Corporation is engaged in designing, manufacturing, and marketing automatic test equipment for the semiconductor industry. The stock saw positive earnings estimate revision of four cents over the past three months for this year (ending August 2018) with an expected growth of 110.20%. It has a Zacks Rank #2 and falls under the top-ranked Zacks industry (top 2%).
Based in New York, NY, Xcel Brands Inc. (XELB - Free Report) operates as a brand management company focused on the acquisition, design, and licensing, marketing and retail sales of consumer brands including apparel, footwear and sporting goods. The stock saw positive earnings estimate revision by a penny over the past three months for this year with an expected growth of 7.69%. It has a Zacks Rank #2 and falls under the top-ranked Zacks industry (top 26%).
Based in Delray Beach, FL, PetMed Express Inc. (PETS - Free Report) is a leading nationwide pet pharmacy. The company markets prescription and non-prescription pet medications, health products, and supplies for dogs and cats, direct to the consumer. Its earnings estimate has risen from $2.15 to $2.28 over the past 90 days for the year (ending March 2019), representing year-over-year growth of 25.27%. The stock has a Zacks Rank #2 and belongs to a top-ranked Zacks industry (top 32%).
Based in Irvine, CA, Tilly's Inc. (TLYS - Free Report) is a specialty retailer in the action sports industry selling clothing, shoes and accessories. It saw positive earnings estimate revision of couple of cents for the year (ending January 2019) over the past three months and has an expected earnings growth rate of 24.62%. The stock has a Zacks Rank #2 and falls under the top-ranked Zacks industry (top 26%).
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