One Writer’s Take on Why Small-Caps Remain So Hot

Oct. 8, 2018 | RedChip Companies

In “The Strong Case for Small-Cap Investing in Today's Market,” an article recently published on, John P. Reese, CEO of Validea Capital Management, lists what he says are the reasons for the recent strong performance of small-cap stocks. Reese also reveals the criteria that small-cap companies must meet to merit inclusion in the Validea Small-Cap Growth Portfolio.

Citing S&P Dow Jones Indices, Reese says that small-caps are outperforming large-caps by the largest margin in eight years. Reese quotes the managing director and head of U.S. equities of Indices, Jodie Gunzberg, who says that smaller companies are outperforming larger companies by 10.1%.

Reese gives two main reasons for the small-cap rally:

  • The tighter domestic focus of small-cap companies. The threat of a trade war affects small-cap companies less than larger multinationals, because small-cap companies derive more of their income from the U.S. market. Higher exposure to the U.S. environment means that tax cuts and deregulation have a more powerful positive effect on small-cap companies. Domestic economic growth and a stronger dollar also influence U.S. small-caps.

  • Mergers and acquisitions, in part the result of the recent U.S. tax reforms and decreased regulations, are driving high performance among small-caps.

Reese lists the criteria a small-cap stock must meet in order to be considered for inclusion in Validea’s Small-Cap Growth Portfolio.

  • TTM after-tax margins must be at least 7%, and they must be “stable” (consistent or growing over the previous three years)

  • “Relative strength” of at least 90. Reese does not offer a definition of relative strength.

  • Revenue and earnings must have grown 25% over the previous year.
  • Inside ownership of at least 10%.

  • Positive operating cash flow, also known as free cash flow.

  • PEG ratio of 0.5 to 0.65.PEG stands for “ratio of price-earnings to growth in earnings-per-share.”

  • Low leverage, i.e., little (or preferably no) debt.

Among the companies meeting at least one of Reese’s criteria are Trex Company (NYSE: TREX), Qualys (NASDAQ: QLYS), Inogen (NASDAQ: INGN), Gorman-Rupp Co. (NYSE: GRC), and AeroVironment Inc. (NASDAQ: AVAV).

Note: In the criteria above and throughout the article, Reese offers no concrete definition of a small-cap company. Readers are left to guess whether by “small-cap” Reese means a company with a market cap of less than $10 billion, less than $1 billion, or less than some other amount.

Even in an age of instant information, Reese says, companies that meet his criteria can escape the attention of investors. Though fundamentally sound, the companies are little-known and not covered by the big media outlets.

The takeaway from Reese’s article seems to be this: In the current economic climate, in which the high exposure of small-caps to a revved-up U.S. market is affecting the entire small-cap sector, investors who apply Reese’s principles can discover particularly strong small-cap companies—companies that, he implies, may even outperform the currently strongly performing small-cap market.

Link to article:

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