It's well known that stocks as an asset class have delivered strong returns over the long run. But if you dig a little deeper into the numbers, you notice that some corners of the stock market have performed better than others.
In particular, small cap stocks have outperformed large cap stocks over time.
According to research from investment management firm Royce & Associates, from 1926-2011, small cap stocks delivered average annual returns of 11.3% compared to 9.5% for the larger S&P 500.
Not impressed? Consider the growth of $10,000 over that period. With the S&P, you would've wound up with $23.4 million. Not too shabby. But with small caps, you would have amassed a remarkable $100.4 million!
And if you zoom in a little further, you'll see that small cap value stocks outperform small cap growth stocks. According to Royce & Associates, from 1979-2011 the Russell 2000 Value index returned an average of 13.0% per year, which is a whopping 400 basis points more than the Russell 2000 Growth index average of 9.0%.
The outperformance of value stocks shouldn't be a surprise to most. Investors are often too optimistic about the growth prospects of glamour stocks and end up paying too much for a future that doesn't materialize. Similarly, they tend to be too pessimistic about the future for value stocks, allowing astute investors to "buy low" and wait for business to turn around.
But why do small caps tend to outperform their larger peers?
There are a couple of theories for their strong performance:
Less Efficiency: Small caps stocks are more likely to be mispriced by the market because they tend to have less analyst coverage and are often overlooked by large institutional investors.
Higher Risk Premium: Smaller companies are riskier than larger companies and usually exhibit more volatility in their prices, so investors require a larger required return to compensate for this risk.
In either case, if you're willing to live with a little more risk, then you might be able to generate stronger stock market returns with small cap value stocks.
4 Small Cap Value Stocks
Using the Research Wizard screening program, I searched for stocks with a market cap between $150 million and $1 billion and low valuation multiples. I also added criteria that a stock needs to have a Zacks Rank of 1 (Strong Buy). Why? Because this indicates rising earnings estimates, and stocks with strong earnings momentum are much more likely to outperform the market than stocks with declining earnings estimates.
Below are 4 small cap value stocks with strong earnings momentum from the screen:
1. PharMerica Corp ( PMC )
PharMerica provides pharmacy products and services to residents and patients in skilled nursing facilities, nursing centers, assisted living facilities, hospitals, and other long-term alternative care settings. It has a market cap of $424 million. Shares of Pharmerica trade at a very attractive 9.8x 12-month forward earnings and 7.9x cash flow. This is in spite of the fact that the company has delivered 10 straight positive earnings surprises. It is a Zacks Rank #1 (Strong Buy) stock.
2. First Defiance Financial Corp. ( FDEF ) is a unitary thrift holding company focused on traditional banking and property and casualty, life and group health insurance products through its three subsidiaries: First Federal Bank of the Midwest, First Insurance Group of the Midwest and First Defiance Risk Management Inc. With a market capitalization of just $228 million, it's not a stock on many investors' radars. But with a forward P/E ratio of just 10.8 and a price to book ratio of only 0.8, perhaps it should be. First Defiance has also seen a big jump in earnings estimates since it delivered a big positive earnings surprise on January 28.
3. American Railcar Industries ( ARII )
American Railcar manufactures hopper and tank railcars and has a market cap of $911 million. The company reported record profit margins and earnings for 2012, and it also reported an average positive earnings surprise of 42% over the last 4 quarters. It is a Zacks Rank #1 (Strong Buy) stock. Despite this, shares trade at a relatively modest 11.0x 12-month forward earnings and 10.3x cash flow.
4. Big Five Sporting Goods Corporation ( BGFV )
Big Five Sporting Goods is a sporting goods retailer with 414 stores in 12 states in the western U.S. It has a market cap of $331 million. The company has delivered three consecutive positive earnings surprises and has seen a sharp increase in earnings estimates for both 2013 and 2014 over the last several months. It is a Zacks Rank #1 (Strong Buy) stock. Shares trade at a very reasonable 13.8x forward earnings and 9.8x cash flow.
The Bottom Line
If you're looking to stack the odds of market-beating returns in your favor, then you need to explore small cap value stocks with strong earnings momentum. These four all fit that criteria.