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4 Must-Watch Small-Cap Stocks to Diversify Your Portfolio Amid the Magnificent Seven Dominance

Mike Cianciabella | October 18, 2024

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4 Small-Cap Stock Picks for When the Mag 7 Fall, According to JB Taylor

As the performance of the large-cap stocks, notably referred to as the “Magnificent Seven” (Alphabet, Apple, Meta Platforms, Microsoft, Nvidia, and Tesla), continues to dominate the market, investors may want to consider diversifying their portfolios with small-cap stocks. JB Taylor, CEO and a portfolio manager at Wasatch Global Investors, emphasizes the benefits of collaboration within his firm and offers insight into the potential of small-cap investments. With its $29.4 billion in assets under management, Wasatch employs a diverse range of 20 domestic and international actively managed small-cap growth strategies.

The Collaborative Approach at Wasatch

At Wasatch, collaboration is a central tenet of the investment strategy. Taylor explains that the firm’s structure is based on the belief that a team of individuals working collectively can achieve a better assessment of market opportunities than a single star manager. “We build teams that really love to work together,” Taylor shares, adding that this collaborative spirit enables them to identify and strategically vet investment opportunities.

The firm emphasizes a long-term perspective in small-cap investments, with the goal of assembling a portfolio of 40 to 50 high-quality companies. Taylor notes, “We aren’t chasing momentum, and we aren’t chasing investment fads.” Instead, Wasatch focuses on identifying companies with significant growth potential before they expand into larger firms.

Investment Strategy in Small-Caps

Wasatch has developed a disciplined approach over the past 30 years. Taylor mentions their use of a DuPont Analysis for screening potential small-cap investments, which assesses three factors: net profit margin, asset turnover, and financial leverage. The firm looks for companies with strong management teams, a track record of line growth, sustainable profitability, and high returns on capital.

Particular emphasis is placed on companies with consistent and rising margins. The firm seeks out names with the potential to double in size within five years, thereby providing a pathway to potential quadrupling over the next decade. “We’re looking for powerful growth but sustainable growth,” Taylor emphasizes.

Corporate Culture as an Investment Factor

Understanding a company’s culture is paramount at Wasatch. Taylor highlights the importance of corporate culture in supporting long-term growth and profitability. “Good corporate culture stresses accountability and profit-and-loss responsibility,” he explains. Wasatch employs a former investigative journalist dedicated to conducting extensive background checks on management teams, ensuring a comprehensive understanding of a company’s culture.

Top Small-Cap Stock Picks

Bearing in mind their investment philosophy, Taylor introduces four small-cap companies that exemplify Wasatch’s growth potential:

1. HealthEquity

HealthEquity stands as the largest provider of health savings accounts in the U.S. Taylor outlines its lucrative business model, emphasizing that it operates in a significant market where healthy employees contribute to these accounts, allowing them to grow over time. Generating revenue from fees and interest on custodial money, HealthEquity’s competent management team is projected to achieve annual earnings growth of 15%.

2. Ensign Group

Operating in the skilled-nursing industry, Ensign Group has carved a niche by identifying talented entrepreneurs to run high-service nursing facilities. With a growing footprint of approximately 300 locations, Ensign is tackling an underperforming segment by acquiring facilities and transforming them into profitable establishments. Taylor forecasts a sustainable growth rate of over 15% annually.

3. BellRing Brands

BellRing Brands specializes in protein production and particularly excels in the rapidly growing protein-shake market. This company thrives on delivering low-carbohydrate, high-protein products that satisfy consumer demand. It operates predominantly through retail giant Costco and exemplifies a high return on capital with an expected annual growth rate of 15%.

4. Investing in International Markets

Beyond domestic small-caps, Taylor hints at the budding potential of international markets, particularly in India. With a surging economy and an expanding middle class, India presents immense growth prospects for companies like Asian Paints. Taylor illustrates that the growing middle class in India can offer sustainable opportunities well into the future.

The Future of Small-Caps

Despite the overwhelming focus on large-cap stocks, Taylor argues that small-cap investments remain attractive, especially now when valuations are at their most appealing in decades. He warns that the momentum driving the Magnificent Seven may not sustain indefinitely, urging investors to keep an eye on the changing tides of market leadership.

In conclusion, collaboration, strong corporate culture, and robust management practices underpin Wasatch’s investment strategies in the small-cap market. As the investment landscape continues to evolve, the firms’ insights pave the way for potential opportunities in underfollowed sectors.