META - Pivoting Away From The Fabulous 7: Small Cap Picks For A 2024 Rotation

2023-12-20 15:50:31 ET

Summary

• Popular trades for 2024 include REITs, long-duration and high yield bond funds, small and mid-cap stocks, and dividend aristocrats.
• Peter Lynch's small-cap wish list includes low institutional ownership, a PEG ratio at or less than 1, a healthy balance sheet, and a price growth rate lower than the earnings growth rate.
• The article provides a list of 18 small-cap stocks that pass Lynch's screens, with a focus on regional banks and Gravity Co. as the cheapest options.

Rolling into 2024

Coming into 2024, there are a few popular trades or rotations, if you will, that are making the rounds. The under-performers of 2023 could be the hot stocks of 2024. Charlie Munger has been quoted as saying that the only individuals that he could theoretically see beating the market, trading in and out for a fund on an annual basis were "sector rotators", although he had yet to meet one at the time. I like to rotate through sectors, but hold on to the cream of the crop deals that I accumulate on an annual basis, what a shame it would be to trade Amazon ( AMZN ), Google ( GOOGL ), or Meta ( META ) for a profit.

I intend to hold my oil picks from 2020-21, bank stocks, and large-cap tech from 2022. I bought them cheap enough, let them be. At most trim a position if it gets well over 5% of the portfolio and stash the excess in a reliable index fund. But I've moved on from the "fabulous" tech stocks. Here are the hot trades I see for 2024:

• REITs
• Long-duration and high yield bond funds
• Small and mid-cap stocks
• Dividend aristocrats which are viewed as fixed-income proxies

My focus is squarely on the above for the most part. Let's examine the underperformance in small-cap stocks and see if some real gems are floating out there adhering to the philosophical ethos of Peter Lynch.

Peter Lynch Small Cap wish list

For those who have thoroughly read One Up On Wall Street and Beating the Street , you will find that Peter Lynch explicitly recommends the below ideas and screens when digging around for small caps. While he is famous for holding thousands of positions in all sorts of stocks and market capitalizations, his recommendations for finding "multi-baggers" always start with small caps. Upon reading you realize that these were the companies that seemed most dear to his heart.

With Small Caps ( VTWO ), ( IWM ) having an off year compared to the broader market, it is a valuable place to hunt. The perception was that interest rates made access to credit more difficult for the less credit-worthy, hence limiting their expansion and possibly putting the smaller companies in peril. The group gets traded down in tandem with index funds following the Russell 2000 largely to blame. I believe many of today's deals are within this segment. Let's take a look at some of Lynch's screens from the two aforementioned books.

• Low institutional ownership

Low institutional ownership indicates a stock that is largely owned by founders, insiders, and early investors who believe in the company versus funds and banks. If the other fundamentals you have calculated turn out to be true, the founders and insiders will help move the stock. Since institutions haven't planted their flags yet, once they catch on, big money can flow into the stock fast. Similar to a new entrant into an index.

• PEG ratio at or less than 1

While Lynch was not the inventor of the PEG ratio, he was the individual that popularized it. Finding companies whose earnings growth rate is equivalent to a growth rate percentage to the P/E multiple was something he always recommended. An example is a company growing earnings at a 25% CAGR with a P/E of 25, this would be a PEG 1. He favored this situation to a company with a P/E of 10 with a growth rate in earnings of 5%. He found the latter to be more expensive than the prior.

Also of note, he recommends staying away from paying P/E ratios over 25 regardless of the company's growth rate. The assumption that more than 25% growth in earnings can be sustained is a fool's errand in my view.

• Healthy balance sheet

Cash or current assets increase while debt is flat or decreasing. These were the main two tenets of a healthy balance sheet trend. Of course, the standard debt-to-equity ratios not being excessive also apply.

• Make sure the price growth rate is lower than the earnings growth rate

A closer examination of Peter Lynch's two books will show you that almost every case study begins with this chart. Comparing the 10-year growth rate in earnings to the 10-year growth rate in price. For ultra high-quality companies, the growth rates will more or less mirror one another over 10 years.

If the price growth rate currently exceeds the earnings growth rate, Lynch would most likely consider this stock overbought and stay away for the time being. If the earnings growth rate exceeds the price growth rate, then this is a great place to start.

The screen

Source: My own excel sheet

These strict small cap screening criteria spit out 18 names in total after eliminating companies listed on foreign exchanges. These are listed in the same order as the stock tickers above:

1. ACNB Corp
2. Southern California Bancorp
3. Capital City Bank Group Inc
4. PC Connection Inc
5. Fidelity D&D Bancorp Inc
6. Gravity Co Ltd
7. Great Southern Bancorp Inc
8. IDT Corp
9. IRadimed Corp
10. John Marshall Bancorp Inc
11. Macatawa Bank Corp
12. Mid Penn Bancorp Inc
13. Marine Products Corp
14. Nicolet Bankshares Inc
15. Republic Bancorp Inc
16. Red River Bancshares Inc
17. United States Lime & Mineral
18. Weis Markets Inc

The picks

Of the 18 above, I like to narrow down the field to my favorite few with closer examinations of the charts and trends.

Of the 18, only 11 passed the test where the earnings growth rate is currently higher than the 10-year price growth rate, they fall into two categories, small regional banks, and others:

The Banks

Non banks

Cheapest picks of the groups

Regional bank group:

• Mid Penn (MPB ): 132% 10 year EPS growth to -32% share price growth.
• Macatawa Bank (MCBC ): 110% 10 year EPS growth to 9.72% price growth.
• John Marshall Bank Corp (JMSB ): 224% 10 year EPS growth to 75% price growth.
• ACNB Corporation (ACNB ): 176.7% 10 year EPS growth to 41% price growth.

The Graham number is the typical way to evaluate the undervalued price target nature of financials. It is simply the price at which the price to book time and the price to earnings do not cross 22.5. It can be obtained by using the formula: Square root of 22.5 X EPS X Book Value. Below are the Graham Numbers for the stocks.

The cheapest of the group is Macatawa Bank. John Marshall Bank Corp is overvalued according to this metric, whittling down the feasible picks within the group to 3.

Next we can evaluate the regional bank's net interest income margins. In this case, I'm using only the TTM interest bearing deposits.

All numbers in millions courtesy of Seeking Alpha

ACNB Corporation has the highest margins, but that often entails risk and lower credit ratings when banks make higher-interest loans. All are doing well on the margin side and trending ahead of most SIB [systematically important] banks.

Future rate cuts for the group will ding margins but should increase overall loan demand which increases originations. Banks make money on both fees and interest margins. Regionals are the go-to small business loan banks, more moderate rates are better for decreasing default risk while offsetting net interest income with increased origination fees. As Howard Marks believes that the FED rate should settle into the 2-4% range eventually versus 0-2%, this should be an optimal sweet spot for both lenders and credit.

Non-bank group

• Gravity Co.( GRVY ) 11.27K% 10 year EPS growth to 4K% price growth
• Marine Products Corp ( MPX ) 168% EPS growth to 82% price growth

Observations

The regional banks ( KRE ) are screamingly cheap. While their balance sheets and capital stability can be a deeper question, this group of small-cap bank stocks fits all the Peter Lynch screens on the surface. Low PEG ratios, good debt-to-equity ratios, fair prices with EPS growth rates above share price growth rates on a 10-year basis. Even just buying a regional bank ETF would seem like a great deal in 2024, this group seems the cheapest of all.

Weiss Markets won't blow your socks off, it is one of the grocers on the list that Amazon will partner with for Prime member direct grocery delivery services. This small-cap is trading at fair value according to the chart and sports a 2+% dividend.

The boat/fiberglass company, Marine Products had a nice dip due to the Covid perceived luxury spending spree being over and a rise in interest rates. However, a drop in rates will further fuel consumer discretionary stocks that have been hammered

Conclusion

The regional banks are cheap amongst small caps with a few non-regional bank small caps to boot that pass the strict Peter Lynch tests. I would rather bet on regional bank ETFs to get my cheap exposure to the segment versus directly buying even the cheapest of the group. To me, a Regional Bank ETF buy seems to be a better play for small caps versus a Russell 2000 index fund.

However, of the group of banks, I plan to buy the below 3 names after whittling down the group through screen after screen. Again those three are:

• Mid Penn
• Macatawa Bank
• ACNB Corporation

Good luck in 2024 to everyone!

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