The Small-Cap Bear Is Here - What Next?

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By SA Marketplace :

2018 seems to be ending on the wrong note in the markets. December is setting the wrong kind of records, and Q4 has been a bumpy one in general. This is what happens in the stock market sometimes, but it's been easy to forget over the decade-long bull market.

We're using the end of the year as a chance to lift our heads, survey the market, and see what might be coming ahead. To do so, we're inviting our Marketplace authors to do a series of roundtables. 2018 was another steady growth year for the platform, and we have a lot of great voices on the Marketplace, so we wanted to share their perspective with you.

Our Year End Marketplace Roundtable series will run through the first full market week in January. We'll feature ten different roundtable discussions, with expert panels chiming in on Tech, Energy, Dividends, Other Income strategies, Gold, Value Investing, Small-Caps, Alternative investing strategies, Biotech, and the Macro outlook.

This roundtable looks at small caps, a part of the market that has lagged meaningfully both this year and over the recent years and tumbled into a bear market this past week (using the Russell 2000 as a gauge). What's going on? We asked our panel to make sense of the situation.

Seeking Alpha: Take the headline indices - Russell 2000 vs. S&P 500 - as a gauge, small caps have lagged large caps persistently over the last five years. What's going on here, and how much does it matter to your approach?

Darren McCammon: Index investing has become more and more popular favoring those companies included in indexes (large caps) vs. those that are not (smaller caps). This makes the large caps more expensive relative to earnings and cash flows. It matters for small cap investors; however, it is also an opportunity. Small caps which are effectively able to grow in size, via internal growth, M&A, increased leverage, or some combination of the above, tend to see multiple expansions over and above the underlying cash flow growth.

Howard Jay Klein: Not much. Small cap companies must occupy the vast media landscape where the battle for eyeballs is just as intense as it is for general media product. As a result, small cap companies find it difficult to gain traction when no matter what their results, it gets washed away in the torrents daily about major large cap companies and media darlings like Tesla ( TSLA ). To me, a good company performance is noteworthy no matter its market cap.

Joshua Hall: Looking back even further, to the early 2009 stock market bottom, the performance of both has been about the same but small caps have been more volatile - generally leading on the upside and downside. I factor this into portfolios by increasing or decreasing allocations more than I do for mid-to-large cap equities depending upon my outlook for the broader market.

Michael Boyd: Most know that this runs against long-term historical trends; small caps have historically outperformed large caps from a straight performance perspective. I think we can point to a few things: 1) Sector exposure. Technology has been the highest-performing sector over most timeframes; the S&P 500 has much more tech exposure than the Russell. Financials, which make up the largest percentage of the Russell, are also one of the worst sectors this year - and really over the past several years as the yield curve has consistently contracted. 2) The market has punished leverage. I track market styles by quartile, and the highest debt/enterprise value firms have underperformed the healthier balance sheet quartile by 12.5% this year. That is massive. I think a lot of this punishment is due to the fears we are late cycle and, of course, rising rates. Going forward, as global growth slows, and the U.S. continues to likely be the safest port in the storm, I think domestically-focused firms are the way to go. That is just easier to find in small caps.

Dining Stocks Online: Large-cap technology stocks have been leading the S&P 500 higher for years now. The FAANG stocks recently accounted for the top five most valuable U.S. companies, in fact. As growth slows, valuation multiples should compress, putting pressure on the S&P 500. When investing in individual stocks, this trend should not really matter, other than to emphasize the importance of keeping an eye out for excessive valuations, which will compress long-term future returns, even if near-term momentum is impressive.

Ruerd Heeg: After researchers showed small caps have on average higher returns funds tried to arbitrage this effect. So, small caps got more expensive and the small-cap effect almost disappeared. But momentum and growth investing became popular again, especially in the past 5 years. Also, investors fled to quality after the financial crisis. On the stock market, investors bought into big companies with steady growth stories like the FANG stocks, but also into hyped stocks. Now, many small caps are overlooked again, and going forward, I think the small-cap effect will be strong, especially for foreign stocks.

Donovan Jones: I research IPOs, most of which are small caps stocks when they hit the market. The IPO market isn't really affected by the headline index performance per se. It is more affected by overall stock market volatility, institutional demand for certain sectors, and major tech IPOs which tend to increase interest by retail investors. So, as such, index performance, as long as it isn't too volatile in a downtrending market, won't impact IPO market activity by itself.

Terrier Investing: As a fundamentals-oriented value investor with a 3 year horizon, I don't spend much (if any) time thinking about overall market dynamics or valuations. They aren't useful inputs into my process. I'm far more focused on identifying attractive bottoms-up opportunities, and I see as many (or more) of those today as I have at any point in the past three years.

Safety in Value: I believe much of the excess return to the large cap indices has come from two places: the outperformance of large cap technology stocks (FAANG et al.) and the continued rise of indexing. While the large cap tech growth has come at least partially from increased earnings of what are (generally) quality, capital-light businesses, there has also been significant multiple expansion over the five year period you mention. Multiples can never perpetually expand, so I would expect the market to come back into balance on that front at some point. Indexing also favors large companies, because their shares are more liquid and easier to use in an ETF. I think both factors have caused a change in the relative valuations of large and small stocks, but that just makes small stocks more attractive going forward, as the lower valuations allow for many firms to either get re-rated or taken over by a larger competitor using its own higher-multiple equity.

Inefficient Market: This has been an issue for several years. I don't think there's one single factor to point to, but rather a multitude of issues, with the largest probably being the amount of money that has been poured into passive investment vehicles over the last 6-7 years. Simply put, individual stocks are competing for a finite amount of investment dollars, and most index/mutual/pension funds are not interested in small companies (no matter how good the growth prospects and value proposition.) I believe this shift to passive investing effectively tilted the demand away from smaller stocks. That said, it hasn't affected the way I invest. I still primarily look for solid companies that are flying under the radar. While it can be frustrating for a stock you own to not receive the valuation you believe it deserves, buying a basket of small undervalued companies has helped me to significantly outperform the market.

The Investment Doctor: I think large caps and small caps are two different breeds as the companies included in large indices are per definition mature, while most small caps are still evolving. And exactly due to the continuous evolution of small-cap companies, the risk levels are a bit higher as well: not every small cap 'makes it'. So, whereas I would have no problem buying an index tracker on a large index, I think individual stock picking could perhaps be more relevant for small-caps. There will be more companies with an unestablished business plan you'd have to weed out before making investments. On the other hand, I also think certain small caps add an additional layer of safety. There are still quite a few small companies that are family-controlled, and those companies de facto represent the family capital. This means the controlling family will make decisions in the best interest of the company with a long-term perspective in mind, instead of a CEO who only cares about his next year-end bonus.

An additional reason to consider small-caps is that it's more likely to see buyout offers as these smaller companies could easily be gobbled up by a larger player. We have had quite a few buyouts this year, as we saw RealDolmen (Euronext Brussels), Produce Investments (London Stock Exchange), Binck Bank ( BINCY ) ( BINCF ) and Telepizza (Madrid Stock Exchange) attract fair buyout offers that provided a clean exit for existing shareholders.

SA: Renewed market volatility in both Q1 and Q4 of this year provides us a reminder that markets can go down and that small-caps are especially susceptible to these moves. How have you positioned your portfolio in this climate?

DM: While I am not a big fan of preferred in general, I have significantly increased the preferred portion of the portfolio. In particular, focusing on preferreds trading below NAV with good cumulative yields and underlying cash flows from long-term contracts which support them.

HJK: I am a contrarian. I see heavier weighting in small caps in volatile times as a smarter strategy than battling through the large cap avalanches.

JH: Except for some mining stocks, I got almost entirely out of small caps earlier this year and have stayed that way even though I remain fundamentally positive on the broad market. The Russell 2000 Growth index is trading for over 30 times forward earnings, and the broad Russell 2000 is still trading for over 20 times forward earnings even after a 17%+ pullback this year.

MB: Many investors got complacent in a low volatility, steadily rising bull market. I think this a major reminder how hedging and shorting have their place in many portfolios. I've been running a short book up to 10-15% of portfolio value this year as well as holding a lot of dry powder on the sidelines. Cash has been the number one performer this year: commodities, stocks, and bonds are all pretty much down universally. As far as asset allocation goes, I feel I've been dead on the money.

DSO: It is not really odd for the markets to have a couple of 10% corrections in a given year. And small caps will always drop more, as they provide more upside as well during long periods of time. Portfolio positioning should not really change, as these dynamics are the norm over market cycles.

RH: I do not try to time the market. Markets are so unpredictable I think it is a losers' game. If I like a stock, usually because it is very cheap based on current financials and multi-year quality metrics, I invest in it. Any strategy has years where it does not work. Therefore, I follow a multi-strategy approach based on 7 quantitative stock ranking algorithms. So, I try to reduce risks by diversifying using different strategies and buying stocks all over the world.

DJ: The IPO market is heavily impacted by general stock market volatility. Big downturns shut the 'IPO window' as institutions pull back from IPO allocations until the dust settles. Stocks that are able to IPO in volatile markets present investors with potentially lower entry points post-IPO. Accordingly, I suggest that during high volatility market periods, investors interested in IPO stocks focus on quality offerings and track those stocks post-IPO for potentially big bargains.

TI: During market selloffs, correlations "go to one" - it's difficult to sidestep selloffs because valuation doesn't matter for individual securities, in the sense that nobody is doing any analysis and picking and choosing which securities to sell - all securities, often regardless of fundamental characteristics, are sold off. For example, just now when the Fed announced another rate hike that the market wasn't expecting, one of my positions that *benefits* from higher interest rates actually sold off *more than* the market, while another one of my positions that would be *challenged* by higher interest rates in fact outperformed the market.

As such, given the difficulty (I'd argue impossibility) of predicting near-term market reactions, I simply try to ignore them and focus on identifying and investing in companies that are likely to deliver substantial returns over the next three years with limited risk.

SIV: I tend to position my portfolio in three "buckets." Net-nets, which are deep value stocks as they have current assets exceeding all liabilities AND the market capitalization of the firm. Then I add general value stocks (usually quality businesses at fair-to-cheap prices) and special situations. Because the different types of investments have different drivers, they have a tendency to balance out volatility on a portfolio level.

IM: I'm at the highest levels of cash I've been in a number of years. That said, there are a number of opportunities that I believe are significantly undervalued, and I'll probably be deploying cash when things look a little more stable. Many great investors have said to not time the market, but having good timing is a prerequisite for trading small companies. While most large-cap stocks aren't going to decline 50% in a correction, it happens frequently with smaller illiquid companies. Try telling someone that's down 50% on a stock in a matter of a few weeks or months that timing doesn't matter. My core holdings have always revolved around value, and that becomes somewhat of a cushion in a difficult market environment.

TID: Volatility isn't a bad thing. Although small-caps tend to trade at lower valuations than the mature businesses in the same sector, a bumpy market may shake things up and avoid complacency on the management level. As an investor, it's important to always maintain a decent cash position in order to take advantage of potential opportunities. When you 'know what you own', averaging down isn't a bad thing.

SA: What was the big story or lesson learned for you in 2018?

HJK: Attention spans of investors have shrunk shorter and shorter and nobody has any patience to sift through analysis looking for unrevealed values unless they have become far too well known and therefore less actionable.

JH: 2018 reiterated the importance of doing your own homework. It is amazing how many times I find that the facts, after hours of work, are quite contrary to the general sentiment. Many professionals are busy running around and have not analyzed the specifics for themselves. They get caught up in the same consensus narratives which are typically flawed. By the way, Seeking Alpha is a great tool for investors to find analysts doing their own homework.

MB: Cheap can get cheaper. While I've always advocated patience and not "buying the dip" immediately, many positions I've bought on the long side have continued to get beaten on by the market. Perhaps it was the bull market, but I had gotten used to market sentiment turning a lot quicker when a deal materialized. With such immense pressure and capital outflow within small caps (Russell 2000 down 15% since August) compounded by tax loss selling, there has been little in the way of relief rallies in the back half of the year.

RH: I believe investors with a consistent method enjoy higher returns. When I started my global deep value newsletter in 2015, I focused on net-nets and low P/E stocks with strong balance sheets. I did not have a consistent way to pick these stocks but used manual screening instead. In the second half of 2017, I found another way to select these stocks: using quantitative ranking algorithms. In 2018, I improved these rankings, based on what my subscribers said and the papers they showed me. I added 5 extra quantitative strategies, again based on papers with statistical stock research shared by my subscribers. So, the big story is how my subscribers gave me advice on improving my already pretty advanced stock selection. When I started in 2015, I expected improvements based on feedback from my subscribers, but not as many as I have implemented.

DJ: The oil patch remains quite volatile. Just because there was a previous downturn in 2014-2016, the recent price support quickly gave way to another bear market, as demand fears coupled with supply increases from within OPEC and in the U.S. shale markets served to hammer pricing yet again. With 2019 likely to see more takeaway capacity come online in Texas, production will likely only increase, further pressuring prices downward.

TI: I'm going to sound like a broken record here, but as a bottoms-up, fundamental value investor, I tend not to have very macro-oriented "thematic" lessons. As I've evolved as an investor, most of my learning has been in the area of refining the sorts of situations that I'm good at evaluating - and spending more time on those, and less time on other types of investments. For example, I've repeatedly learned over time that "deep value" - including dumpster diving, asset plays, etc. - is just not something I'm really well-equipped to evaluate or execute on, so I've consistently moved up my minimum "quality" threshold for even spending any time looking at a company.

Perhaps a couple broader lessons I've learned: first, to try to do a better job of overcoming my natural aversion to ideas that are popular. For example, Interactive Brokers ( IBKR ) has been a perennial favorite among small-cap investors focused on quality businesses, and in retrospect, I probably should've been more open to the idea several years ago. One of the mental blocks for me was - "if everyone loves this so much, how can it still be a great value?" (No position now or previously.) Going forward, I'm trying to do a better job of focusing more on an idea's merits and tuning out who likes or doesn't like it.

Second, and similarly, I've realized that it's internally inconsistent to A) believe that I have no edge in interpreting near-term price action, and B) prefer buying securities that have fallen over the near to medium-term past than securities that have skyrocketed. Although a large portion of my gains are undoubtedly due to averaging down, I've also found that averaging up can be profitable if the fundamentals are improving faster than the valuation. Similarly, some of my worst picks have been companies whose share prices have fallen dramatically, while some of my good ones have been companies whose share prices had risen meaningfully. As with the previous item, I'm now trying to focus more on the "signal" - i.e. the idea's fundamental merits - and less on the "noise" - i.e. whether it's recently up, down, or sideways.

SIV: The big story at the Microcap Review this year was an increased focus on merger arbitrage and special situation investing. As value got harder to find, I focused more of my time on special situations. These have the advantage of not having much market exposure, and having short timelines. So, as the deals play out, I am getting more cash to deploy into new ideas after valuations have come down.

IM: My portfolio is on pace to return just shy of 30% this year. If you would have told me that at the beginning of the year, I would have been disappointed. Mostly because this is my lowest return over the last 8 years, and I was really optimistic heading into 2018. But seeing how smaller stocks have collapsed over the last few months, it's difficult to complain with making nearly 30% in a down year. Looking back at 2018, I would have done things differently only with the benefit of hindsight, which is a chance life never gives you. At the time I was making investments, it seemed like the right move. Some worked out, some didn't, but that's life in the stock market.

TID: Further referring to my answer on the second question, instead of being patient and waiting for the good opportunities in the small-cap sector to come to me, I made the decision to add two large-cap companies to the ESCI portfolio. These investments didn't yield the desired result, and unless those positions get sold at a loss, the cash remains 'locked up' in these investments instead of being able to do some Christmas shopping in the small-cap space.

SA: Where do you fall out on the spectrum of 'well-diversified portfolio' and concentrated portfolio 'because my 50th best idea won't be as good as my 5th'? Why?

DM: In theory, I would like to keep 25-30 different investments. However, I just don't know of 25-30 different good investments nor have the capacity to adequately follow the 100+ names it would take to get to 25 worth investing in. Thus, I suggest members use other services or ETFs for the large cap, foreign and other portions of their portfolio which I don't cover.

HJK: Midway. I like a portfolio divided in thirds: One third concentrated in a sector I know well, one third in a sector behaving very well, and one third pure speculation stocks based on instinctive sense of momentum.

JH: Let me give it to you straight ... I target 15 stocks in the portfolios I manage. I find this provides the right balance of diversification and opportunity for significant outperformance. It also requires me to look harder to separate the wheat from the chaff which provides an added analytical benefit.

MB: I run a highly concentrated portfolio, especially on the long side. To be blunt, I don't believe that any independent investor can get an edge in the market while holding more than 25 or so positions - and that is if they do this full time. In any given week, I'm spending 15-20 hours of my time on existing holdings: reviewing the latest SEC filings, checking recent macro trends, updating models, engaging with senior management and major shareholders. Small caps represent a massive opportunity for smaller investors. Lower liquidity and less specialized coverage mean that many active institutional investors just do not get involved. But that doesn't mean a couple hours of due diligence every quarter is enough to stay abreast of change.

DSO: Studies have shown that the added diversification from an additional stock in a portfolio wanes materially after one gets to 15-25 positions. As such, a 50 stock portfolio is probably overkill. That said, 5 or 10 names provides excess risk.

RH: I recommend diversification, but only if there are enough good ideas. Here is my solution. I compare thousands of global stocks twice a month using 7 quantitative strategies. Each month I research 20 stocks from my 7 quantitatively ranked lists. That provides me with many stocks to choose from. Therefore, my 50th best idea might be not as good as my 5th idea, but the difference is much smaller than for most other investors.

TI: While I own 17 stocks, my largest position is ~40% of AUM, and my top 7 account for ~90% of AUM. I tend to think about position sizing on a position-by-position basis, by which I mean that each company has different risk factors that reflect on appropriate position sizing. For example, a company with a compelling valuation, but meaningful debt and/or meaningful exposure to a highly cyclical end market, might be worth investing in, but only as a small position. Conversely, companies without those risk factors might merit much larger positions if their valuation is far more compelling than the rest of my watchlist.

SIV: I keep a very diversified portfolio, generally with a few dozen ideas at any one time. Micro cap companies are more susceptible to "something" going wrong, so over-concentrating is generally not something I do. However, I strongly believe that well-selected micro caps as a group outperform because the market ignores them. Instead of getting my diversification from a few large well diversified firms (and how well did that go for GE anyway?) I prefer to get my diversification from a larger number of carefully selected small firms.

IM: I generally like to keep a basket of around 20 companies. My higher conviction ideas will generally get a larger weighting in the portfolio. Because I trade smaller companies that are inherently more risky, even if I have a really good idea, I won't put a huge chunk of my portfolio in it. Because in this business, you never get hit by the train you see coming. I've seen stocks that looked like sure things and then they step on a landmine that you couldn't see coming, even with the best due diligence. Fortunately, many of my larger positions have worked out over the years, and I do consider myself an aggressive investor, but preservation of capital is always a top priority.

TID: There are thousands of small-cap companies in Europe, so it would be a miracle if only a handful companies would be worth investing in. While it makes no sense to invest in hundreds of companies (then you are better off buying a small-cap index ETF), I do think it makes sense to invest in several different stocks. It reduces the impact on the overall portfolio when an investment goes south, while you are also increasing the odds of seeing a buyout in the portfolio. As long as you can explain exactly 'why' a company belongs to be part of a portfolio, there's no real limitation to the amount of companies you can invest in. The ESCI portfolio, which was started with a size of 100,000 EUR, contains approximately 30 positions.

SA: Hypothesis: with trade tensions, oncoming U.S. political gridlock, and political concerns popping up across the world, small-caps are a safer place to invest because they are less exposed to these issues. Agree or disagree, and why?

Lutz Muller: Agree. Small caps are better investments if you pick your geography - the looming trade war between the U.S. and China are going to hurt the Chinese and the U.S. economy but can benefit European companies. Small caps are also much less exposed politically than large caps since they are unlikely to become victims to retaliatory tit-for-tats between the U.S. and China, the U.S. and the EU and the U.S. and Canada.

DM: Identified issues tend to be priced into the market, plus some. So, these challenges, if temporary, actually represent opportunity. I for instance have little clue when the trade war will be resolved; however, I can identify companies whose stocks have traded down in sympathy with the trade war yet whose underlying business and cash flows are not actually affected by it. This doesn't mean these stocks won't continue to trade down and up with sentiment surrounding the trade war; however, it does mean their business and underlying cash flows will survive and continue to thrive regardless of what happens with it. So, once the issues are resolved, those businesses and cash flows will still be there when sentiment recovers.

HJK: Agree. Once again, small caps tend to fly under the radar of big headline events, so they appear to be more immune to the market and less exposed.

JH: I generally disagree and the data confirms this. Since January 2017, the S&P 500 has outperformed the Russell 2000 by 10%. Keep in mind that small caps also sell products to large caps. That being said, you really have to take each industry or stock on a case by case basis.

MB: Agree completely. I don't like unknowns in my investments and trade/political tension is one of the greatest question markets heading into next year.

Anyone following my public coverage this year has seen this come through in my coverage, including advocating for pair trades. One of my favorites in the casino space, for instance, Red Rock Resorts ( RRR ), is basically a pure play on the regional gaming market in Las Vegas. They have little exposure to international tourism that even the Las Vegas Strip casinos hold. Pair trading that firm against international firms (like Wynn ( WYNN )) has been a great driver of alpha while controlling for market/sector specific movement.

DSO: Small caps are never "safer" investments than large caps. They tend to be less diversified in terms of customer bases, less established, and have worse balance sheet and a higher cost of capital. You are not going to see a situation akin to the S&P 500 dropping 20% but the Russell 2000 only declining 10%.

RH: Agree. Many of my investments are largely independent from the general economy. Instead returns are often determined by idiosyncratic and often unpredictable events. We know deep value investing works, but it is better to explain it using psychology instead of economic fundamentals. That is different with many big companies. Moreover, many big companies have still a lot of air in their stock prices.

DJ: Given that even small caps are global companies in many respects, I don't believe they are materially less exposed as a class. Many still participate in global supply chains, which are affected when trade tensions require major market participants to reconfigure those supply chains to avoid tariffs or reduce exposure risks. It is more important for investors seeking alpha to focus on which small caps stand to gain or lose based on shifting market conditions in their industry, rather than a 'fire and forget' approach to investing in small caps as a whole.

TI: I don't actually know the macro characteristics of all small-caps, i.e. the international/domestic revenue/EBITDA exposure for the R2K vs. the S&P 500. What I can say is that yes, at least within my coverage universe of small caps, there tends to be a far more domestic skew than in larger companies - and, as a corollary, small-caps benefited disproportionately from the tax cut, which is not priced in to many of the names I follow.

That said, everything's interrelated - so, for example, while few of my names are directly impacted by tariffs, undoubtedly many of them sell to customers which will be impacted by tariffs, or have suppliers who will be impacted by tariffs, so it's difficult to know the full extent of the situation until it plays out.

SIV: I think that is even more true of micro-caps then it is of small caps. As an example, I own shares in a small recycling company. It has a local moat, as it would never be economic for a competitor to duplicate its capacity in the local area. It sells within a small local area, doesn't export its products or import its raw materials. The CEO is never going to get arrested in China in a tit-for-tat situation, in fact, nobody ever really notices them. But they pay a strong dividend and have a great moat. I'm happy to quietly make money outside of the headlines, and I think microcap stocks have that potential in a world with increasing political/trade volatility.

IM: Agree, and this was the play throughout much of 2018, until it wasn't. In an overall down market environment, nothing is really immune (with respect to equities). Some places are better to hide than others. I consider myself a value investor, and even value stocks have been performing poorly recently. However, when the trend reverses and things stabilize, I believe small-caps will greatly outperform large-caps in the coming years.

SA: What are you preparing for in 2019? Any big themes to watch out for?

LM: I would watch the big retailers (Target ( TGT ), Walmart ( WMT ), Amazon ( AMZN ) etc.) and how they exploit the two major drivers for market share - one is their effectiveness in attracting and holding Toys"R"Us consumers who are looking for a new home;' the other is the continuing shift to online at the expense of brick and mortar. I would see any major positive change in these two parameters for these retailers as a long term "Buy" opportunity. Equally, I would monitor the secondary retailers [notably J.C. Penney's ( JCP ), Kohl's ( KSS ), and Barnes & Noble ( BKS )] and track their progress in both parameters as well and view any negative trends as a clear "Sell" sign.

DM: Macro themes include companies that can do well despite interest rate increases; and secular growth in worldwide natural gas production, transport and usage. Searching for superior management capital allocation strategy, companies whose underlying cash flows represent a solid yield compared to price, and companies that for one reason or another are going to be able to grow cash flow per share are permanent ongoing themes.

HJK: I see a great interest forming in neglected consumer discretionary stocks.

JH: All 3 of the major base metals that I follow - copper, nickel, and zinc - have inventories at 5-year lows and all 3 are in structural deficits, meaning prices are going to have to rise to spur more production. The miners of these stocks have been beaten down and are great values, as is, however, if the trade tensions get resolved (at least in the consensus narrative) and everyone wakes up and says "the U.S. is just fine, China is improving, etc.", then these miners are set up for an absolutely explosive run because the "trade fears" have been like a lid on a boiling pot of fundamental strength. In this scenario, copper and zinc could conceivably see panic spikes higher because exchange inventories are so depleted.

MB: 2019 just looks rough because companies will be facing slower GDP growth (declining year over year comps), and there will be no tailwind from tax reform for EPS estimates. The S&P 500 posted ~8% revenue growth in Q3 2018 but ~26% earnings growth. Coupled with that, margins are at all-time highs. I think investors might be in for a surprise next year when comps come in at the mid to low single digits on EPS and revenue growth. I'm in the process of ramping up my short book personally. I think 2019 ends with the S&P 500 lower than where it starts.

DSO: Earnings growth is going to grind to a halt. Mid to high single digits is probably best case scenario, and closer to zero is not out of the question. Valuations have come in nicely, but stock prices will be capped due to lack of catalysts for earnings growth in 2019.

RH: I continue looking for the cheapest and least liked stocks in the least liked markets. Such investments have the best potential for great returns. These stocks can be found anywhere, but currently there are more in Russia/Ukraine (trading in the UK or the US), Turkey, Greece, Poland, PRC (trading in Hong Kong or US) and Japan. Investors trying to time the market can use my research and quantitative rankings on momentum stocks and falling knifes. Falling knives with low EV/Revenue are known to be good investments and even more so if they got low in times of high market volatility. Also, previous momentum stocks are great investments when the market starts to pick up again. So, falling knives and momentum stocks can both be big themes to watch for.

DJ: For the IPO market, I'm expecting some major tech names to go public in 2019. Uber ( UBER ) and Lyft ( LYFT ) are set to battle for investor capital in early 2019, while several other highly-valued private tech companies are gearing up to IPO. Many of these firms raised large sums of capital from private institutional investors since 2014, and those investors are likely becoming quite impatient for the opportunity to exit their positions. Look for multiple 'hype' periods in 2019 for the IPO market as these tech companies and others seek public capital before the end of the longest bull market.

TI: See previous answers - my approach doesn't really change based on macroeconomic or market conditions. I have a watchlist of 131 interesting companies and my focus is on continuing to build that watchlist to 300 companies, and keeping current on the companies already on that list.

TID: The volatility will very likely remain on the markets, so that's definitely something I am trying to prepare for. That being said, at European Small-Cap Ideas we don't have any specific themes. We invest in companies that appear cheap, and let the management do their jobs to grow the company. It would be nice to see an additional 3-5 buyouts in 2019 as well. It's an easy way to exit a position and reinvest the proceeds in existing and new positions.

SA: What is one of your best ideas for 2019, and what is the story?

DM: Archrock ( AROC ) is a company that leases natural gas compressors to energy production and pipeline firms in North America. These compressors are the backbone of natural gas transport. North American natural gas volumes being transported continues to rise as worldwide demand for this relatively clean burning energy source undergoes a multi-decade increase. Archrock benefits from this. Archrock also benefits from having a lower cost of capital than its two primary competitors USA Compression ( USAC ) and CSI Compressco ( CCLP ). Despite these attractive attributes, investors can get a cheaper price (based on EV/EBITDA multiple), and a higher implied growth rate on AROC than its competition. The primary reason for this is AROC pays out a lower dividend, instead keeping more of its cash flow to internally fund future growth and or pay down debt. So, you can get a double-digit dividend from USAC and CCLP (14% and 17.6%, respectively), or a more modest dividend (5.3% as of this writing) from AROC albeit with a higher implied growth rate and meaningfully less cash flow risk. The choice is up to the individual investors needs and goals. All three benefit from the underlying secular growth in North American natural gas transportation volumes.

HJK: El Dorado Resorts ( ERI ). I tagged it at $17, it's gone to over $40, based on what I see as a major trend in consolidation of the US Casino Sector.

JH: Australian-based OZ Minerals ( OZMLF ) is a low-cost copper producer with an exceptional growth pipeline, all in safer jurisdictions. Its 3rd mine, Carrapateena will come online in 2019 and be fully ramped up in 2021. Carrapateena sits at the bottom of the cost curve with C1 cash costs of around $.50 per lb. (translation - more free cash flow). A little further out (e.g., 2022-23) OZ is poised to bring West Musgrave into production. West Musgrave holds the largest undeveloped nickel sulfide mine in Australia, and possibly the highest grade open-pitable nickel sulfide mine in the world on a nickel equivalent basis. The electric vehicle market needs class 1 nickel for battery cathodes and sulfide deposits are the primary and best type for it. Higher grade (i.e., generally lower cost) sulfide deposits are also more rare. At the same time, nickel is poised for a severe structural deficit next decade. My long-term target price for nickel is a more conservative $7.25, but ultimately, we are either going to see nickel rise to $9 to $12 per lb. for at least a few years, or there will not be an EV revolution in its current format. There is plenty of class 1 nickel supply available at $10 per lb. OZ has no debt. They generate enough cash internally to fund their growth pipeline and pay a quality dividend (~3%). The stock is trading for only 4.7 times my 2020 earnings estimate and only 3.1 times my 2021 earnings estimate at my target long-term copper price of $3.17. OZ has huge upside as this base metals bull cycle regains its footing.

MB: So many to choose from. Taking one fresh on my mind, Front Yard Residential ( RESI ). The firm trades at a massive discount to net asset value ("NAV"), and management has been doing an excellent job in solving the problems that have led to that disconnect (lack of scale, external management, reducing costs). They are in the process of digesting a major acquisition, and management has been extremely happy with the process and outlook into 2019. In my opinion, they've got a great path forward on sequential comps (funds from operations ("FFO")) and are positioned well as far as their real estate. I think given time, management will drive the share price higher. But major shareholders, frustrated on the pace of the business, are likely to push for either a buyback (which management does not want to do) or an outright sale or merger. And I think there are a lot of potential buyers out there: Conrex, Amherst, Tricon, Progress Homes, and any other PE buyer that wants an "in". I wouldn't be surprised to see a proxy battle to replace many on the Board of Directors.

DSO: Del Frisco's Restaurant Group ( DFRG ) at $6 and change per share. The stock has lost more than half its value in 2018 after management overpaid for the Bartaco acquisition ($325 million for fewer than 20 locations) and issued a bunch of stock at $8 after announcing the Bartaco deal when the stock was at $15-$16. Activist hedge fund Engaged Capital has since acquired a 10% stake at prices between $6 and $7 and will help halt the horrid capital allocation practices at DFRG. The stock could easily rebound to $10-$12 per share is management focused on operational excellence and improves capital allocation strategies. A buyer for the business could always be lurking as well.

RH: A great idea, but not a small cap, is still the Genzyme Contingent Value Right ( GCVRZ ). This is a litigation play, but not a class action. The GCVRZ trustee is suing Sanofi ( SNY ) on behalf of investors. I think there are very good chances on a huge pay out in a couple of years. Check out my instablog article for details.

DJ: Since I focus on IPOs, my general recommendation will be for interested investors to avoid getting caught up in the 'hype cycle' for particular IPOs, especially Uber ( UBER ). Many will have a 'fear of missing out', or FOMO, response as the media cranks up the pros and cons for well-known companies like Uber. In 2018, the big media 'hype cycle' occurred with the Spotify ( SPOT ) IPO. The stock has since performed poorly post-IPO and is trading well below its IPO price, so it is important for IPO investors to be disciplined and avoid overpaying for company stock offerings, no matter how much media attention it gets.

TI: My largest position is Franklin Covey ( FC ) - a corporate training company that has successfully transitioned from a discrete-sales model to a recurring-revenue SaaS model over the last few years. The company's new product, All Access Pass, delivers incredible customer value, which has led to 90%+ revenue retention and strong new customer additions as well as population expansions at existing customers. The company is on track to deliver high single to low double digit annual revenue growth for a very long time, with operating leverage leading to teens to twenties EBITDA growth.

Examining the long-term history of peers like Gartner ( IT ) with similar business models, Franklin Covey is clearly a compounder, yet it's trading at a "value" multiple of ~10x this year's true Adjusted EBITDA (adding back deferred revenue less associated costs) and ~1.3x revenue. This is a nonsensical multiple for a high-growth, high-margin, recurring-revenue business; the stock trades in the low $20s today, but I believe it's worth $46. This is based on intrinsic valuation, but transaction and peer comps are also supportive of my valuation work.

SIV: My best idea for 2019 is Horizon Group Properties ( HGPI ). The company owns interests in 8 outlet malls, which have been much more resilient than regular shopping malls - no exposure to failing department stores, and much lower operating costs. Even though outlets are doing much better than standard malls, HGPI is trading below 3X P/FFO, and about 20% of book value. The company is a dark microcap that doesn't pay a dividend, so there isn't much to attract regular REIT investors, but the valuation here is so compelling that I think small cap investors looking for a capital gain opportunity should be looking at it. The shares are down 35% in the last 6 months, which I believe is an exceptional buying opportunity, and I have been adding to my position.

IM: My best performing idea in 2018 was a payments company called 3Pea International ( TPNL ), which was up over 600% at one point. So, in keeping with that theme, I'm going to go with another payments company for 2019, Payment Data Systems ( PYDS ). I had owned this company several years ago, and it performed well for me, but then they started reporting lackluster results and I lost interest. But now a few years later, they are starting to grow organically again, and have brought some high quality new hires on board. They should be back to EBITDA profitability in the current quarter, and there are some exciting growth prospects in the pipeline. Add in the fact that it only trades for 1x revenue in an industry that averages multiples of around 4x revenue (for much lower growth rates), and I think this could be a big winner again.

If I had to pick one stock that I think is just really cheap and deserves to be much higher given the results that have already been reported, it would be Perion ( PERI ). This is a company that is trading for about 2x cash flow and 2x Adjusted EBITDA. The fourth quarter is by far their strongest of the year, so there could be an immediate catalyst in the early part of 2019.

TID: Seeing how the share price of BW Offshore ( BGSWF ) got slaughtered the past few months (down more than 50%), I am convinced the company will do well in 2019 as the market will start to realize the oil production business is only a small part of the business model. The majority of the revenue and EBITDA is generated through the FPSO division; BW Offshore provides vessels for offshore oil & gas production, and the deployment of the ships is usually backed by multi-year contracts. The real money-maker is the BW Catcher, which has been leased to Premier Oil ( PMOIF ) ( PMOIY ) for its Catcher field. The agreement has been fixed for an initial term of 7 years, but can be extended by an additional 18 years. Considering BW Offshore and Premier Oil have been talking about BW Offshore also delivering an FPSO for Premier's next offshore oil project, both parties get along very well, and I'm very confident the agreement will be extended after the initial contract term.

BW Offshore will have to take care of its unemployed vessels. As of right now, 4 vessels were unemployed, and one of them will be scrapped (resulting in a $20M cash inflow). There are some contracts expiring in 2019, so I think the market has been waiting to see some official contract extensions which will provide a better earnings visibility. BW Offshore has been hinting at a contract extension and a redeployment for two FPSO's on Petrobras ( PBR ) contracts. Should both deals indeed materialize, BW Offshore will be able to reduce its perceived risk associated with some of the shorter-term contracts. Let's also not forget 2019-2022 will be a busy three years for new FPSO tenders. Petrobras is planning to develop several new oilfields, and I expect BW Offshore to secure at least 1 and maybe 2 new FPSO contracts.

The FPSO activities as well as the own oil production offshore Gabon should push the FY 2019 EBITDA to $500M. BW Offshore's current market capitalization is approximately $680M, and the enterprise value is approximately $1.8B. Unless they need to build a new FPSO in 2019, a large part of the EBITDA will be converted into free cash flow.


Thanks to our guests for shedding light on the small-cap space. If you'd like to check out any of their work, here are the links:

Stay tuned to this account for the continuation of the Year-end series. We'll start publishing again on December 26th. For those celebrating, have a happy holiday season and see you soon.

See also What's Behind The Market Reaction To Powell's Comments On Quantitative Tightening? on seekingalpha.com

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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