Big Gains In A Small Package

1/19/2010


Small-capitalization stocks lagged midcaps and large-caps last year. But that doesn’t mean they should take a backseat with investors.

The S&P MidCap 400 Index paced the market’s recovery with a 37.4% advance in 2009, topping the 25.6% gain of the S&P SmallCap 600 Index and 26.5% gain of the S&P 500 Index of large-cap stocks. The S&P 400 MidCap was also the best performer over the last three and five years. However, over the last 10 years, the small-cap and midcap indexes delivered roughly similar returns well above those of the S&P 500. And for longer periods of time, small-caps look even better. From 1926 through 2008, small-cap stocks averaged annual returns of 14.9%, versus 13.4% for midcaps and 10.8% for the largest stocks.

15-year performance snapshot — 1995 to 2009
—— No. of Years ——
Standard
Deviation
Largest
Gain (Year)
(%)
Largest
Loss (Year)
(%)
Gain of
10%+
Loss of
10%+
Positive
Returns
5
Yrs.
(%)
15
Yrs.
(%)
S&P SmallCap 600 Index
38.8
(2003)
-31.1
(2008)
9
2
11
21.0
19.5
S&P MidCap 400 Index
37.4
(2009)
-36.2
(2008)
11
2
12
19.6
18.1
S&P 500 Index
37.5
(1995)
-37
(2008)
9
3
11
16.0
15.8

Long-term returns aside, small-cap stocks have appeal for several reasons, including the three below:

Small-caps have historically delivered better profit growth than larger stocks, and the next fiscal year should be no exception. The average stock in the S&P SmallCap 600 Index is expected to deliver nearly 22% growth in its next fiscal year, versus 19% for components of the midcap and large-cap indexes. Over the next five years, consensus estimates project annualized profit growth of 13% for the average S&P 600 company, versus 10% for the average S&P 500 component.

While Quadrix works on stocks of all sizes, it is highly effective for small stocks, as the table below shows. Smaller stocks on average earn lower Value scores than large stocks, but identifying small-cap stocks with strong valuations can lead to highly effective results. As a group, small-cap stocks that earn strong Value scores deliver greater outperformance versus peers than any other combination of stock size or Quadrix category. High Overall scorers have also generated particularly impressive outperformance in the small-cap space.

WHAT'S WORKING BY MARKET-CAP SEGMENT
The effectiveness of Quadrix depends on the size of the company. Below are category returns within each of the 10 market-cap divisions of the U.S. stock market, based on rolling 12-month holding periods since 1990. For example, within group 10 (the smallest firms), the top one-fifth of stocks based on Momentum score outperformed the average of all the stocks in group 10 by an average of 5.1%.
—— Average Return of Top Quintile Minus Average of Each Set ——
Market-Cap
Segment
Momen-
tum
(%)
Value
(%)

Quality
(%)
Fin'l
Str.
(%)
Perfor-
mance
(%)
Overall
(%)
10 (microcap)
5.1
4.2
(2.3)
(1.8)
2.0
2.5
9 (microcap)
2.7
4.1
0.6
2.6
4.8
4.7
8 (small-cap)
1.7
5.4
1.0
2.3
1.9
5.0
7 (small-cap)
2.7
5.2
3.2
3.0
2.0
5.5
6 (small-cap)
2.2
3.9
3.0
2.7
3.9
5.3
5 (midcap)
2.1
4.7
0.7
0.4
2.9
3.8
4 (midcap)
3.2
3.7
1.6
3.0
4.2
4.0
3 (midcap)
4.2
4.8
2.9
2.1
3.8
7.1
2 (large-cap)
3.3
3.6
3.8
1.0
3.8
5.5
1 (large-cap)
1.9
1.8
3.2
3.3
3.5
5.3

As the table below illustrates, there are many more small-cap stocks than midcaps or large-caps. Within that huge opportunity set, we can usually find plenty of appealing options.

There is no universally accepted definition of a small-cap stock. For this story, we used a method that splits New York Stock Exchange issues into 10 deciles based on stock-market value, then slots non-NYSE stocks into those deciles. Based on this method, the market capitalization of small-cap stocks falls between $470 million and $1.75 billion. This range changes over time as the market ebbs and flows. For more information about the breakdown, including divisions for midcaps, large-caps, and microcaps, check out the table below.

Small-cap stocks have a reputation for high risk, and in fact they can be quite volatile. But over the last 15 years, the S&P 600 Index’s worst price change — down 31% in 2008 — was at least five percentage points better than the weakest years for the S&P 400 and S&P 500 indexes.

In the following paragraphs, we review three small-cap stocks from Upside, our sister publication that focuses on midcap and small-cap stocks. Dow Theory Forecasts focuses on stocks with market caps of $2.5 billion or higher. Subscribers interested in small stocks should visit www.UpsideStocks.com.

EZCORP ($18; EZPW) operates pawnshops and payday-loan centers in the U.S. and internationally. The stock has jumped 66% since June but still trades below its three-year historical averages for trailing price/earnings, price/cash flow, and price/book ratios. EZCORP has a stock-market capitalization of $880 million.

The payday-loan business faces legislative scrutiny that could ultimately reduce its profitability. At the same time, regulations tend to heighten barriers of entry for pawnshops, sheltering EZCORP’s other business. Funded by rising cash flow, EZCORP’s 2010 expansion efforts focus on adding more pawnshops in Mexico and payday-loan shops in Canada.

In fiscal 2009 ended September, revenue rose 31%, the sixth consecutive year EZCORP reported double-digit sales growth. Wall Street projects 11% higher sales and 18% profit growth in fiscal 2010. Earning a Quadrix Overall score of 100, EZCORP is an Upside Best Buy.


Lancaster Colony ($51; LANC) earns a Value score of 85 and has a market capitalization of $1.43 billion. The specialty-foods business (87% of revenue in fiscal 2009 ended June) features popular retail brands for salad dressings, vegetable dips, croutons, caviar, frozen bread, rolls, and noodles. Lancaster’s other segment (13% of revenue) sells candles, home fragrances, and glassware.

Wall Street expects Lancaster to grow per-share earnings by 27% in fiscal 2010. That target may be aggressive, but Lancaster’s per-share profits more than doubled over the last four quarters, along the way beating the consensus by at least 21% in each quarter. Lancaster, which yields 2.4% and has raised the dividend in each of the last 47 years, is an Upside Best Buy.


Odyssey HealthCare ($16; ODSY) provides end-of-life services in 29 states. These hospice services, mostly covered by Medicare, give terminal patients the option to die at home rather than in a hospital. While hospice care is rising in popularity, Odyssey says the market remains underserved. Hospice tends to reduce Medicare costs during patients’ last year of life, a time when expenses usually surge.

In the first nine months of 2009, profits more than tripled to $0.87 per share, while revenue rose 14%. The average number of patients under Odyssey’s care jumped 10% to 12,364, and revenue per patient day rose 4%. Wall Street expects per-share earnings to rise 8% this year, a target Odyssey should be able to top. The company has proven it can manage expectations, having beaten the consensus by at least 17% in the March, June, and September quarters. Odyssey, with a market capitalization of $542 million, is an Upside Buy.

DISSECTING THE MARKET
Smaller stocks tend to earn lower Quadrix Overall and Value scores. However, there are many more small stocks than large stocks, and our Upside newsletter finds plenty with investment appeal.
—— Market Capitalization ——
—— Quadrix Scores * ——
Stocks With Overall
Scores Above 80
Average
—— 12-Month ——
Market-Cap
Breakdown
Minimum
($Mil.)
Maximum
($Mil.)
Average
($Mil.)
No. of
Stocks
Overall
Momen-
tum
Value
No. of
Stocks
% of
Stocks
Avg.
Trailing
P/E
Ratio
EPS
Chg.
(%)
Total
Return
(%)
10
(microcap)
25
228
99
1,538
41
48
45
228
15
15.3
(2.5)
30
9
(microcap)
228
470
329
621
48
50
48
113
18
17.7
(9.2)
31
8
(small-cap)
470
770
607
434
51
51
49
85
20
18.4
(7.7)
39
7
(small-cap)
770
1,186
956
323
53
50
52
71
22
17.2
(9.0)
38
6
(small-cap)
1,187
1,748
1,446
268
56
54
51
57
21
20.3
(6.1)
43
5
(midcap)
1,751
2,589
2,163
243
58
51
53
57
23
17.9
(7.7)
38
4
(midcap)
2,593
3,878
3,200
213
60
53
58
56
26
18.3
(3.7)
43
3
(midcap)
3,880
7,064
5,155
219
59
51
54
56
26
18.0
(9.6)
45
2
(large-cap)
7,066
16,824
10,622
207
64
52
59
70
34
16.2
(6.0)
41
1
(large-cap)
16,936
322,668
59,646
200
66
50
61
61
31
16.9
(11.0)
33
* Quadrix scores are percentile ranks, with 100 the best.

 


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