3 Small Cap Picks. Plus, Balancing the Magnificent 7

Data is everywhere. When orchestrated properly, it sings. At Morningstar, we analyze and enrich data, making it actionable and powerful for you. Morningstar, where data speaks.

The reason why small-cap growth has been in a bear market for almost 3 years is mainly because we experienced the fastest and most furious rate hikes. So now whether we pause or cut, big picture is that we are at the end of the rate hiking cycle. So the headwind is going to turn into a tailwind.

Hello and welcome to the Barron's Streetwise Podcast. I'm Jack Howe. The voice you just heard, that's Amy Zhang. She manages a variety of small and mid-cap funds for Alger. And in a moment, she'll share a few of her favorite stocks. We'll also talk a bit about what to do about AI blophobia. That's the fear that a handful of giant tech companies are making up too large a percentage of your index fund. There's no pill for AI blophobia, but we will explore some, let's say, financial therapies. Listening in is our audio producer Meta. Hi Meta. Do the therapies include reflexology? That's the one where— is that, is that with needles? Reflex? What is it now?

Feet.

Feet. It definitely includes feet. We'll come to it. How about we start with a listener question? Yeah, we have one from Michael.

Hi, Jack. My name is Michael. I live in Bluffton, South Carolina. My question for you is where I can look for growth outside of big tech, because I feel like I'm living in a sort of big tech purgatory. For years, I've been told that the best way to invest is to put my family's money into a diversified ETF or an index fund, and that the best way to do that is to buy the S&P 500. The problem is by doing that, I'm not really buying a diversified asset. I'm really buying the S&P 7 with a few hangers-on, and that feels perilous after so long. Given that I'm in my early 30s and have a long time horizon, I've searched for alternative paths for growth. Unfortunately, value ETFs continue to be disappointing. Equal weighted S&P 500 funds seem to be a way just to miss out on the Magnificent Seven's returns. I've been hearing that it's time for small cap ETFs to shine for years, but that doesn't seem to happen. If I go to growth-focused ETFs, whether they're passively or actively managed, they all have most of the Magnificent Seven as their top holdings. Do I accept that this is the Magnificent Seven's world and I'm just living in it? Or can an investor with a long timeline like me confidently buy an ETF that avoids stocks and still get growth? If so, where do I look?

Thank you, Michael, and shout out to Bluffton, South Carolina, which bills itself as the heart of the Lowcountry. Although you say you feel like you're living in big tech purgatory, and I can see what you mean. Those big 7 tech companies, Apple, Microsoft, Alphabet, Amazon, Meta, Nvidia, Tesla, they continue to run ahead of the rest of the S&P 500. I saw a chart recently from Apollo, the private equity manager. It said the S&P Seven, which is their term for the Magnificent Seven, they said it's up 80% so far this year, whereas the S&P 493, that's the rest of the index, is basically flat. It also said that the S&P Seven is priced at about 50 times earnings, which makes it as expensive as The Nifty 50 in 1972. Matter of fact, that's the year I was born. Don't do that math in your head. It's also the year that the Nifty 50 peaked. These were a group of blue-chip companies that investors came to believe would just be kind of a good deal at, I guess, any valuation. They included names like Coca-Cola, McDonald's, Texas Instruments, IBM, Xerox, and Polaroid. Obviously, mixed results since then for that group. Coca-Cola has done great, Polaroid not so much. I'll tell you two interesting things about the Nifty 50. One is that they went on to do poorly for the rest of the 1970s. I guess because the starting point was pretty expensive. But two is that they have done all right since then for people who bought at the peak in 1972. And that's even considering that some of the companies fell out of relevance over the years. And I guess the lesson there is that if you buy good enough companies like Coca-Cola and McDonald's and you hold for a long, long time, even if you're paying lofty prices when you buy them, you can still do okay in the long run. I really couldn't tell you if that's going to be true today of the S&P 7, or Magnificent 7 as you say. People are paying 36 times earnings for Microsoft, which seems ambitious, but could it work out well over the long term? Sure, it could. 25 times earnings for Alphabet, 31 times for Apple. Amazon is up there at 68 times, but that's a company that is building quickly from what has historically been a lower base of profitability. We mentioned in a past episode about how free cash flow for all of these companies is rising quickly. The two names that stand out on the list as having a long way to go economically to justify those share prices are Nvidia and Tesla, but we'll see. Okay, so Michael, you're essentially asking how could you go about diversifying away from these 7 stocks? But then you say value hasn't worked, small caps haven't worked, so you don't want to do those. That's going to be tricky because what is the nature of the S&P 7? What's the nature of the weighting of the S&P 500 right now? It's dominated by large companies and it's dominated by growth companies. So if you wanted to counterbalance that somehow, you would have to have more of a weighting in value and smaller companies. And the fact that they've done poorly to me is not a reason to avoid them. In fact, it might even be a reason to buy them. But it has been a long wait, as you say, for investors who've been told that those two groups of stocks are about to come around any minute now. Let me give you two answers that try to thread the needle for what you're talking about, which is diversifying away from those seven stocks without really going into small caps, without really going into value. One is a NASDAQ 100 equal weight ETF. There's one out there with the ticker symbol QQQE. We just talked on this podcast recently about buying a NASDAQ index ETF. I don't get it. I don't know why people would want to have stocks that trade on one particular venue as their investment theme. But one reason might be that you want more tech exposure. The NASDAQ certainly has it, but with the equal weighting of this index, you don't get that dominance by that handful of big companies. So, you're getting an index that still has 36% weighting in information technology. I'm not recommending that ETF. I'm just saying maybe that kind of does what you're thinking about doing. Another approach, but you have to have a lot of money, is to go to a financial advisor that offers custom indexing. This is a service usually provided for, let's say, executives at companies that are members of the S&P 500. They might have compensation plans that leave them loaded up with their company shares and they want to pursue indexing as a strategy, but they don't want to buy even more of their company's stock through their indexing strategy. So they might go to a financial advisor that can use individual stocks to mimic the performance of the index minus their company's stock. You could do that and just say that you want to mimic the performance of the S&P 493. I don't know, by the way, why there is not an S&P 493 ETF out there. There seems to an index ETF for everything under the sun. I know we've spoken in the past in this podcast about the MEME ETF. The ticker, I think, was MEME. That's from Roundhill Investments. And that popped up in response to people chasing after shares of GameStop and other meme stocks. I just saw an announcement that that ETF is closing this year. So that thing was kind of like a pop-up taco truck, financially speaking, in that it appeared and people put money into it and they followed a trading strategy. And now it's going away. I don't know why you couldn't have a pop-up financial taco truck for the S&P 493 and see if people are into it. Maybe there will be one at some point. Meta, what would it be called? Magnificent Sevenless?

The Leftovers?

The Leftovers ETF from Pop-Up Advisors. Ticker MEHH with two H's. So Michael, your other choices are you could buy your own individual stocks, or if you want to stick with indexing and you don't want to buy a value index and you don't want to buy a small cap index, I suppose you could buy a fundamental index. Do we all know what those are, Meta? Should I explain?

Yeah, I think it's good to explain.

It's basically, we've mentioned Research Affiliates and that's one company that does it. Um, you basically create an index where you weight it by something other than stock market value. You use some other factor. So some people call these factor ETFs, factor funds. Let me give an example. There's a fund called Invesco FTSE RAFI US 1000 ETF. That's an atrocious name with way too many acronyms. Invesco is an investment company. FTSE stands for Financial Times Stock Exchange. RAFI is the company that developed the, the index that stands, I believe, for Research Affiliates Fundamental indexes or indexation. And then you've got the US 1000 or 1,000 companies in here, and it's an ETF. The ticker, that's what you need, it's PRF. PRF like pretty run-on fund. Anyhow, that fund holds, like I said, 1,000 companies, and it weights them according to 4 different measures of firm size that are not stock market value. And the 4 are book value, cash flow, sales, and dividends. So these are 4 measures of economic value, and the index uses a, a blend of them to select the companies or to weight the companies. And that's a pretty easy-to-understand methodology. There's also a fund company out there called Dimensional Advisors, and their goal is to produce better returns in the overall stock market using academic research. They look for things that studies have shown to produce handsome returns over time.. And the approach is flexible. It can change over time as new research comes out. I spoke recently with Gerard O'Reilly. He's a co-CEO and CIO at Dimensional. Here's Gerard on what the company does.

Our kind of goal, I would say, has always been each day, can we build a more perfect portfolio? Each day, can we curate a more perfect client experience? That's what we charge ourselves with every day. And in pursuit of that more perfect portfolio, it's, can we actually get the returns that you see from academia? When the academic does an experiment using historical data, they might show small caps having higher returns than large caps, but can you accomplish that in real-world investing? And what we've been able to demonstrate over time is that by pursuit of that more perfect portfolio, our more perfect client experience, that we've been able to deliver the returns that are out there for markets are delivering that academics have been able to identify.

Thank you, Gerard. Two things I can tell you about Dimensional. A few years ago, they launched some ETFs based on their processes, so it's become easier for individual investors to buy in. Also, Barron's each year publishes a ranking of fund families, and in its most recent ranking, that's early this year, Dimensional was listed at number 17 for the 5-year ranking, but at number 1 for the 1-year ranking based on its performance in 2022. I'm reading from that story. It says last year's volatile conditions fit right into the Austin, Texas-based firm's wheelhouse. Dimensional is known for its roots in academic research on factor investing, particularly involving value investing. And its tendency to favor smaller companies that are highly profitable. As such, the firm sidestepped the meltdown in mega-cap growth names and companies with few, if any, profits. Okay, so Michael, that's Dimensional Fund Advisors and Research Affiliates. Those are two ways to go about factor investing or fundamental-based investing, which is— it exists somewhere in the middle between pure index investing and active management. It's a way to go about being more selective on stocks, but with a process rather than full-on stock picking. So those are some other ways for you to get out of, what was it called again? Meta big tech purgatory.

Yeah, that's what Michael called it.

Yeah. I want you to get out of big tech purgatory and into small cap value limbo. No, no, definitely not. I— Large cap value abyss. No, that's, that's even worse. I was gonna say Balanced allocation paradise. Yeah, that sounds better. Coming up after the break, we'll speak with Amy Zhang of Alger about small-cap stocks.

Data is everywhere. When orchestrated properly, it sings. At Morningstar, Morningstar. We analyze and enrich data, making it actionable and powerful for you. Morningstar, where data speaks.

Welcome back. Let's get to some small cap stock picks. I had a chance recently to speak with Amy Zhang. She manages small and mid-cap funds for Alger. Let's play part of that conversation now. I heard recently from a listener who said, what do I do about this heavy weighting in these big 7 tech stocks in the S&P 500? How do I diversify away from that? And he says, I know you're going to say value stocks or small-cap stocks, but people have been saying that forever, and when are they going to come around? So I wonder, what are your thoughts on that? How attractive do small caps look right now, and do you have any sense of when their day is coming when they're going to begin shining versus large caps?

Right. That's an excellent question. I think small-cap growth particularly is extremely attractive just in terms of valuation. The S&P 600 small-cap growth is trading roughly as of now around a 22% discount to S&P 500. So, you know, historically in the last 20 years, it's been trading at an average premium of about 14%. So you can see, you know, the valuation gap is so wide that a truck can drive through it. And we've already seen some reversion to mean, right, just in November. Because the reason why small-cap growth has been in a bear market for almost 3 years is mainly because of we experienced the fastest and most furious rate hikes, right? So now whether we pause or cut, but no matter what, the big picture is that we are at the end of the rate hiking cycle. So the headwind is going to turn into a tailwind going forward, I think.

The rate hikes have been a headwind. Is that because that an investor might worry, well, you know, smaller companies don't have the same levers to pull as large companies when it comes to raising capital or refinancing debt and they might have a more difficult time refinancing their debt. What is it that you think has been more of a headwind for these small caps and small-cap growth stocks with the rising rates?

When people think about small-cap, right, and they just immediately associate with risk and then they feel like, you know, recession— recession is about like waiting for Godot, right? We've been talking about for so long. And I think just generally, people's perception sometimes is a bit misguided, is all small caps are risky and they are highly levered and they cannot control their own destiny. They're going to have a tougher time in the higher-for-longer, you know, the interest rate environment. But I think for small cap growth, especially at Alger, you know, we focus on a lot of companies that, you know, very science-based, you know, innovation-driven. They're very capital-light, strong balance sheet, and they can control their own destiny because they usually have something truly different. They're very small, law of small numbers, right? That's one of the key reasons I love small cap, that they can gain a lot of market share in a large expanding market. And regardless of the economic cycle, right, they actually can do well. So that's the difference between small cap growth versus small cap value. But I think this year has been, or even last year, you know, broad brush, you know, people sort of just want to wait for the recession to be over to invest in small cap. But I think it's turning around a little bit because Again, it's highly correlated to rates, and the rates, we are, you know, at the peak or close to peak. So you could see the catch-up is already happening, and we think there'll be more catch-up going forward.

Earlier, you made a reference to Waiting for Godot when you talked about the recession. I think I get the reference. That's a play about people who are waiting around for someone who doesn't show up. I saw a version of that play. It had John Goodman in it on Broadway, and I sat pretty close to the front. He has a very loud voice when you sit close to him like that. I don't remember all the details of the play, but I've got that right. People are waiting for it and it doesn't come. Is that the idea?

Yeah, it's one of my favorite plays. I watched it in middle school in Shanghai, actually, you know, where I grew up. So I feel like it's waiting for Godot, right? Because we talk about recession forever and a lot of it, I think, is machine-driven in terms of the volatility of small cap. But I think this is a great time to find those gems in the rubble, so to speak.

How do you find the best small-cap growth stocks? What kinds of attributes are you looking for? And when you go looking for those attributes, what parts of the market do you find that your search is bringing you to again and again?

You know, I think at the core of what we do is identify investing in exceptional small companies that have the potential to become exceptional large companies. Most small companies are junkies, right? They don't make it to the end. And so we look for companies that can really sustain transactions of mutual benefit. So how do they do that in a durable, sustainable way? And they usually will need to have very, you know, strong and wide moats, you know, that typically those companies are science-based. And that leads us to, you know, sort of healthcare and technology that is truly innovation-driven, like the product can disrupt or transform a market. Because of a law of small numbers, usually, you know, we define smallest in terms of revenue, which is also very unique from our peers because I think revenue is a better indication of size than market cap. So we typically would invest in companies with $500 million or less at initial point of investment. So it's really about the company gaining market share because they're truly differentiated in a large and growing market. And a lot of times they go from one product to a platform of products. You know, they have both unit growth and expansion of wallet shares. But at the core, you know, we pay a lot of attention to the competitive advantage of a company, and only through a strong and wide moat that we believe that company can sustain their revenue and profitability growth over the long term. Of course, management is very important too. There's a small company, you know, you have limited resources, so how to allocate capital, right, and balance profitability and growth is extremely important.

Can I ask you for some examples of stocks that you like? What are your favorites right now within your portfolio?

Well, we have a lot of companies, but maybe we can illustrate one of our top positions, a long-term holding, is called PROS Holdings. The ticker is PRO. It's a software SaaS company that specializes in price optimization.

SaaS, meaning software as a service. Meaning that they're doing some sort of recurring billing, like a subscription service for what they do.

Is that the idea? Yes, exactly. Over 80% of revenue is recurring. But what is really special about PROS is that they've had like over 30 years of utilizing AI and machine learning platforms, both generative and predictive AI, to turn data into actionable information. For insights for the sellers. And that's a common theme I want to say. You know, we always want to invest in companies, especially in the tech area, company can turn data into actionable insights for their customer and really address the pain points for their customers. And for Prose, for a small company, they spend a lot on their R&D. They spend, you know, 25 to 30% of their revenue in their R&D, and now they're reaping the rewards of that. And in terms of fundamentals, the company is now at the inflection point of becoming cash cash flow positive. So we really believe that they are really well positioned for accelerated growth and the margin expansion in the years to come.

Let me ask you about that. That's a difficult thing for investors to figure out. Investors get used to saying, okay, this company is 15 times earnings, this company is 25 times earnings, what have you. But when you've got one of these smaller companies, which, as you say, this is a company that has been loss-making in past years, it is expected to begin turning a profit and generating free cash from, from this year, and then, and then a rising amount going forward. So what do you look at to figure out whether you're getting a good deal? Are you projecting those free cash flows out into the future?

Yeah, that's an excellent question, because I think the key difference between small cap versus large cap is small cap, a lot of it's sort of like you got to see things under the hood, right? So PE is usually not a good measure because especially for S companies, right? Like, you know, the E is usually depressed. So it's really more about like knowing the company well, I think, you know, and for PROS, they would have been profitable much sooner, but COVID, you know, disrupted their growth trajectory, right? Because they started in the airline industry, right? Like doing the price optimization, real-time predictive analysis for airlines, and then they've been expanding to other verticals. Now finally they're successful, but because of COVID their growth was derailed. So sometimes, you know, I think for a small company like that, I really believe understanding reduces risk.

Okay. So that's Prose Holdings. What other stocks do you like?

You know, we've been long-term holders of Wingstop as well. We've owned it for over 7 years.

Now that's a company I think I can get my head around. You said Wingstop. That is the, uh, it's a sports bar, but it's kind of like a family atmosphere.

Uh, I'm not sure. I felt like Wingstop is more for takeouts. It's sort of like you watch Super Bowl, you will order Wingstop.

Oh, you know what? I got my wing restaurants confused. I'm sorry. I've never had the pleasure of taking out wings from there. What makes that business special?

I really feel Wingstop is like a technology company that sells chicken wings because they are very innovative, right? Their aspiration is to become 100% digital. Like every transaction will be digitized. And now they are well on their way because they already, you know, about 70% transaction digitized. And it's also a great business model. Most of their business is franchised. They have unique economics, which leads to the highest cash-on-cash return, about 60%, which is the highest in the restaurant industry. So they have a rare combination of durable and strong unit growth and same-store growth. We think they still have a long runway for growth. Now they have a little over 2,000 restaurants. We think they can grow to 7,000 restaurants, and largely due to, you know, a lot of international expansion. So this is really a kind of company that exemplifies what we look for as a long-term compounder.

Have you tried the wings there?

Yeah, absolutely. We order, you know, takeouts, and they have all sorts of flavors, and they also expanded their menu as chicken sandwich is fantastic. So I think this is a great example of small-cap consumer company that really has durable and sustainable revenue and profitability growth.

I'm getting a little hungry. What about one more stock that you like?

Yeah, of course. One of our other large holdings is Appfolio. Appfolio is also a cloud-based software company that really focuses in the property management vertical.

What's the ticker on that one? APPF. Appfolio. Got it.

So, you know, we always want to invest in companies that can address a pain point for customers, right? Like the property management industry is very paper-based, so they really provide a system of record to automate a lot of business processes and really cut down a lot of costs and improve efficiency and productivity for their customers. And they're a very small company still, but its addressable market is really large and growing because the digitization of real estate management is still in its early innings. And then also they have a significant leadership of using AI in the space. So it's very important, I think, to invest in companies who will be beneficiaries, whether it's user or enabler of AI, because I think AI is truly disruptive and transformative. And the company itself that really optimized their cost structures, they also invest a lot in R&D in the past years. Are coming to fruition. So we're expecting to see a significant, you know, margin expansion going forward.

And when you say real estate software, I'm looking at the website here, I'm trying to think, what do you need your software to do if you have a lot of real estate? They list maintenance, they list accounting, staffing. I suppose you use this to screen potential tenants, maybe to collect rent from tenants. So there's a lot going on here in suite of software.

Yeah, and they're expanding their software, right? So initially, well, just like you said, it's back office reporting and accounting, right? And they also get into payment, but over the years they really expanded. So we always look for both depth and breadth in our companies. Only through that they can truly grow. I think they're really in a very sweet spot doing that.

Thank you, Amy and Gerard and Michael. And thank you all for listening. Meta Lutzow is our producer. Meta, you might not be here next week. You might not be here for a little while. Do we tell people why? Should I give a hint? Sure. Give a hint. Um, double babies. Have I said too much? They'll never guess. Incoming babies. Babies incoming. Well, it's very exciting. Congratulations. And we can't wait to hear more. Subscribe to the podcast on Apple Podcasts, Spotify, wherever you listen. If you listen on Apple, you can write a review. My voice went up there like I'm going to say something else, but I think I'm out of things to say. That's kind of it, right? Going to bring the voice down now.

Ready?

Thanks. And see you next, see you next week. See you next week.

That feels That was very satisfying.

Data is everywhere. When orchestrated properly, it sings. At Morningstar, we analyze and enrich data, making it actionable and powerful for you. Morningstar, where data speaks.