Five Oversold Small Cap Stocks And One Mid Cap For Bear Market Bargain Hunters

The S&P 500 is hitting new 2022 lows in this year’s brutal selloff leading up to Wednesday’s Federal Open Market Committee meeting where the Federal Reserve’s policy committee is expected to hike short-term interest rates aggressively to tamp down inflation. The large cap index is down 22% from its peak on the first trading day of the year and tumbled 10% in just the past week as the latest readings on inflation showed price increases accelerating. For small caps, the market’s stumble into bear market territory has been exceptionally severe, with the Russell 2000 index down 30% from its peak last fall and back to pre-pandemic levels.

There could be plenty of near-term volatility ahead as the Fed accelerates its rate-tightening cycle. JPMorgan and Goldman Sachs both expect a hike of 75 basis points this week, even though Fed chair Jerome Powell dismissed that possibility at its last meeting a month ago. Last week’s 8.6% inflation reading put central bankers on their heels. But with the stock bloodbath already well underway, investors and asset managers are licking their chops at some valuations, if they have dry powder to deploy.

“The risk in the stock market is far lower today than it was six months ago just by virtue of the correction that we’ve seen. A lot of the excesses are being flushed out as we speak,” says Nicholas Galluccio, co-portfolio manager of the $57 million Teton Westwood SmallCap Equity fund. “We think it’s a perfect setup for possibly a strong 2023.”

Galluccio’s fund has outperformed the market, losing 13% so far this year after a 30% gain in 2021, to earn a 5-star rating on Morningstar. He’s been on offense this year adding to his positions in several small caps trading at low valuations, including Carmel, Indiana’s KAR Auction Services, which builds wholesale used car marketplaces and generated $2.3 billion in 2021 revenue.

Used car retailer Carvana bought its physical auction segment for $2.2 billion in February, larger than the market cap of the company at the time, though the proceeds were used to pay down debt. The acquisition prompted a 38% one-day pop in KAR’s stock, but it has given back most of those gains in the recent correction. The deal hasn’t been as kind to Carvana, which has lost 91% of its value this year.

“We got very lucky that Carvana we believe overpaid for their physical auction business for $2 billion, which is an enormous sum,” Galluccio says. “Now they’re strictly digital with a virtually debt-free balance sheet.”

Another of Galluccio’s picks is Texas-based Flowserve (FLS), which manufactures flow control equipment like pumps and valves. Many of its customers are petrochemical refiners and exploration and production companies in the energy industry. Most energy-linked businesses have had a strong year with the price of crude oil surging, though Flowserve has lagged with a 5% decline. Its bookings rose 15% in the first quarter to $1.1 billion, and Galluccio expects its margins to improve as it builds its backlog.

Value investors are also looking at oversold areas of the market for stocks trading at tiny multiples and now offering attractive dividend yields. John Buckingham, portfolio manager and editor of The Prudent Speculator newsletter, likes the Whirlpool Corp. (WHR), a century-old home appliance manufacturer headquartered in Benton Charter, Michigan. With home sales falling, Whirlpool has exposure to an anticipated recession, but its stock is down 34% this year, trading at six times earnings, with a dividend yield over 4% and an appetite for buying back shares. While not a small cap, at $8.7 billion in market capitalization, this mid-cap has long been a favorite of value investors.

“Lower home sales are certainly a headwind, but the market has already discounted something far worse than what we think will ultimately occur,” Buckingham says. “If we have a quote-unquote ‘mild recession,’ I think that many of the businesses have already been priced for a severe recession.”

Another consumer business Buckingham singles out from his portfolio: Foot Locker (FL). The shoe retailer is down 36% this year, including a 30% drop in one day on February 25 when it said its revenue from its biggest supplier Nike NKE +2.5% would decline this year as the apparel giant increasingly sells directly to customers. Now, Foot Locker trades at a tiny 3.5 times trailing earnings, with a 5.7% dividend yield to attract income investors.

While those value plays are cheap, Jim Oberweis, chief investment officer of small-cap growth firm Oberweis Asset Management, makes the case that growth stock valuations are even more attractive after taking the worst of the selloff so far. The Russell 2000 growth index is down 31% this year, and Oberweis’ small-cap opportunities fund has declined 22%. One outperformer is its top holding, Lantheus Holdings (LNTH), which has already more than doubled this year.

Lantheus makes nuclear imaging products that can be injected into patients and make body parts glow during medical scans to help diagnose diseases. It received FDA approval last year for a product called Pylarify which can identify prostate cancer, and fourth-quarter revenue rose 38%. The Massachusetts-based company trades at about 20 times expected 2022 earnings.

“It’s very hard to find a company at 20 times earnings with those growth numbers and those kinds of moats in terms of patents and defensible market positions that are very difficult for competitors to attack,” Oberweis says.

Oberweis boasts that Lantheus has no correlation to the broader economic environment and recessionary fears. Some of his other top holdings do have some inflation exposure but have already been deeply discounted this year and are trading at multiples more typical of value names. Axcelis Technologies (ACLS), which sells components to chipmakers like Intel INTC and TSMC to make semiconductors, grew its revenue by 40% in 2021 and another 53% in the first quarter of 2022, but has declined by 25% this year and trades at 15 times trailing earnings.

“Small growth stocks, which have been bludgeoned, I think have much better prospects to do well in an inflationary environment because many more innovative companies have pricing power, the ability to quickly raise prices and get the customers to actually pay them,” Oberweis says. “I don’t know if it’ll be this year or next year, but I think people buying right now are likely to earn significant positive returns because of the low valuations.”