This Valuation Metric Bodes Well for Small Caps in 2019

Today, I want to talk about a very important valuation metric that is quite bullish for small-cap stocks moving forward. But first, let’s step back from the market for a second and talk about something a little lighter. Like insects.

Of the nearly 1 million identified species of insects out there my favorite might just be the banded wooly bear caterpillar.

In the larvae stage this 13-segment creature is covered with brown hair in the middle, and black hair at the extremes.

They’re undeniably cute, always look cozy, have no gross appendages poking out anywhere, and it’s impossible not to smile when you see one.

The wooly bear doesn’t bite, it isn’t poisonous, and it won’t cause a rash.

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It’s also not very fleet of foot, which makes it exceptionally easy to catch. The insect’s defensive stance – they just curl up into a ball and lie still when disturbed – makes them easy to pick up and pass around with the kids.

The wooly bear is also an incredible evolutionary specimen. It has adapted to survive temperatures down to -76 °F. This is accomplished by the production of cryoprotectants, an anti-freeze like substance that protects the caterpillar’s organs and brain from freezing solid when harsh conditions arrive. This is one of the reasons the wooly bear has the longest life-span among its peers, living up to 14 years.

Perhaps the wooly bear’s most attractive attribute is its ability to predict the future. Legend has it that the more brown segments a wooly bear caterpillar has, the milder the upcoming winter will be. Fewer brown segments (i.e. more black ones) means a more severe winter.

I think that investors – who are somewhat obsessed with looking for reliable market indicators to predict the future (especially in a down market) – can appreciate that this seemingly simple creature is trying to tell us something!

Is the wooly bear reliable?

In 1948 Dr. C. H. Curran, the curator of insects at the American Museum of Natural History in New York City, began an eight-year span collecting and analyzing caterpillars in an effort to prove the insect’s predictive abilities.

He found a trend and concluded there might just be some merit to the legend.

I wouldn’t recommend buying your clothes based off the number of brown segments on the wooly bears around you. But it’s still an interesting example of people looking for any possible insight into impossible-to-answer questions about the future.

These Two Charts Say the Market Should Go Up Soon

The big question on everyone’s mind right now is, of course, when will the market go back up? Or, at least, when will it stop going down?

Fortunately, market data is more readily available than caterpillar data. And I’ve come across some that’s relatively robust in terms of predicting what’s going to happen in the near future.

It regards the stock market’s quarterly returns throughout a presidential cycle, and most notably, following midterm elections such as the one we just had.

The data is summarized in the chart below from LPL Financial, who collected data from 1950 through 2017. The punchline is that in the fourth quarter of a president’s second year (i.e. the quarter that ends in a couple days), the market tends to go up. The data also shows that in the following two quarters the broad market delivered positive returns well over 90% of the time (Q1 of year three) and roughly 70% of the time (Q2 of year three).

This chart and a key valuation metric bode well for small caps' rebound in 2019.In other words, history suggests that the stock market will go up soon.

Of course, history doesn’t always repeat. LPL Financial had a second chart that looked super compelling a few weeks ago, but not so much today. The chart is below, and it shows that since 1950 the S&P 500 delivered a positive return after reaching an October low through year end 100% of the time in years in which there were midterm elections. The average gain was 10.7%. I don’t know if they used intra-day or closing lows, but in either case the S&P 500 needs to stage a nice little rally this week in order to keep that streak alive. And even if it did this year would likely pull that average down a little.

An Encouraging Valuation Metric

Let’s step away from historical data and look at what small-cap stocks are doing now.

They’ve corrected over 20% from their 2018 high and are down over 14% for the year. They, along with most other stock indices, look like garbage (if looking at a chart).

In terms of valuation, small caps are trading with a forward P/E of around 14.3. That’s really cheap. The S&P 600 Index hasn’t traded with a valuation metric this low since 2012.

It’s worth noting that analyst earnings estimates are coming down. Not by a ton (yet), but they have pulled back a little. Still, consensus estimates point to decent EPS growth of 15.5% in 2019 and 15% in 2020.

Comparatively, the expected EPS growth rate for the S&P 500 Index is 8% in 2019 and 10.5% in 2020. That index trades with a forward P/E of around 14.5.

Put together this means small caps are expected to grow EPS faster, and trade at a valuation discount to large caps. Growth in both asset classes isn’t bad, and both are relatively inexpensive as compared to recent history, on a forward P/E basis.

Obviously, there is more to think about than how stocks have performed through previous presidential cycles, what analysts think and what a particularly valuation metric means for small caps. But let’s say you’re either an adventurous or market-hardened soul (or both) and are thinking about snapping up some stocks in the near future.

Where to begin?

The Best Small-Cap Stocks for 2019

The best place is with the stocks in Cabot Small-Cap Confidential. Our stocks haven’t been immune to the selling, but I cover quality names and I’m confident they’ll be among the strongest in the market when things turn up.

Now’s the time to see what we have, read up on the stocks, their stories and their growth prospects, and figure out which ones work for you. Start buying slowly, and increase exposure when the market starts to look better.

One of my favorite stocks in the portfolio right now is disrupting the insurance industry. In this market a company is lucky if they’re growing at 5% in that industry. But this company is growing revenue at over 40%, and it’s profitable! Better yet, there’s potential for a special dividend in the first quarter of 2019.

The secret to this company’s success is a hybrid go-to-market strategy and a robust technology platform that simplifies every step of the process, both for sales reps and consumers.

It’s just one of many stocks in the Cabot Small-Cap Confidential portfolio that is disrupting a big market. And it’s the place I’d start when building a portfolio for 2019.

Get a head start on the New Year by clicking here.

Tyler Laundon

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Tyler Laundon is chief analyst of Cabot Small-Cap Confidential. The circulation of Small-Cap Confidential is strictly limited because the undiscovered stocks with sky-high-potential that Tyler recommends are often low-priced and thinly traded. Don’t share these recommendations!

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