The Russell 2000 is known as the world’s “biggest small index”. It offers investors the chance to invest in the heart of America. These small- and mid-cap stocks are diverse and offer more domestic focus than the multinational giants at the top of the S&P 500. In addition to providing important portfolio diversification, smaller companies typically outperform in the long run, owing to their greater scope for long-term growth.
Excluding the “Magnificent Seven” from the S&P 500’s return in 2023, it reveals that the remaining 493 stocks actually lagged the Russell 2000. Small caps have recently traded on historically wider discounts to large caps. However, 37% of the Russell 2000 index is unprofitable, and small caps have an average leverage ratio of 4.3 times. Disparities between market averages and individual stocks require active management to identify the winners and losers. Our investment process focuses on three key attributes: quality businesses, quality management and attractive valuations. Here are three firms that meet these criteria.
US small cap safe bets
MSA Safety (NYSE: MSA) is the global leader in the development, manufacturing and supply of safety products that protect people and facilities. MSA’s core products include self-contained breathing apparatus and other protective gear for firefighters; gas and flame detection systems used in a variety of industrial settings; and industrial head protection and fall-prevention equipment. Given the mission-critical and non-discretionary nature of safety products, MSA tends to experience less cyclicality than other industrial companies, with regular replacement of safety equipment often mandated by law. The company makes a healthy profit and requires limited capital investment, driving strong and durable cash flows.
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Encompass Health (NYSE: EHC) is the largest operator of patient rehabilitation facilities in the US. As rehabilitation services are needs-based, patient volumes tend to be non-cyclical, while also benefiting from demographic trends as the US population ages. The combination of steady revenue growth, attractive profit margins and strong cash flows is a testament to the quality of the business, and we think Encompass’s strong management team and attractive valuation make the stock a promising investment.
MACOM Technology Solutions (Nasdaq: MTSI) designs and manufactures semiconductor technologies for optical, wireless and satellite networks. Macom has diversified exposure to applications in the industrial, telecommunications and data-centre markets, with the company’s multi-decade record and more than 600 patents underpinning a strong competitive position.
US small caps powered by artificial intelligence
Macom generates very attractive profit margins and strong cash flows, and is run by a management team with a history of creating value for shareholders. Recently, shares have benefited from the group’s exposure to optical components for artificial intelligence (AI) applications with data centres, which has driven a strong rally in shares. While we’ve taken some profits on recent strength, Macom remains a high-conviction position for the long term.
The US economy remains strong, with falling inflation and rising real wages offsetting dwindling savings and tighter credit conditions. We think moderate consumption growth should carry the US economy to a soft landing. We remain positive about small caps thanks to compelling valuations and strong fundamentals. Robust earnings growth, combined with low valuations, could drive small caps to regain the momentum of 2000-2011, when they outperformed. Investors remain underexposed to small caps. However, as their fundamental merits are rediscovered, we anticipate a return to the sector.
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