By the time the dust settled in 2013, small caps won the day (well, year) — the SPDR S&P SmallCap 600 (SLY) had outperformed the SPDR S&P 500 ETF (SPY) by almost 9 percentage points.
Each time SPY has a good year, it seems SLY has an even better one. Since 2006, when SPY delivered at least 15% annual returns, the ETF of small caps beat SPY on average by 740 basis points. In the years where SPY didn’t do well, SLY only did slightly worse.
What kind of year are we in for in 2014? Most Americans see a flat or lower stock market this year while experts seem to be slightly more optimistic, expecting high-single-digit or low-double-digit gains from the S&P 500 in 2014. So really, that’s not actually great news for the small-cap index.
With the five-year bull run getting long in the tooth, the route to success might be a modified Dogs of the Dow approach, picking last year’s small-cap laggards to be this year’s winners. Bespoke Investment Group has a table that shows how 2013’s worst-performing stocks from the S&P 1500 fared in the first week of 2014, and I have picked three small caps from that list that I like to outperform in 2014.
Small Caps to Buy #1: Aeropostale (ARO)
In December, I looked at the trio of teen retailers that includes Aeropostale (ARO), Abercrombie & Fitch (ANF) and American Eagle (AEO).
While I came to the conclusion that AEO has the best business of the bunch, I was confident that an experienced CEO like Aeropostale’s Tom Johnson would be able to return it to profitability in 2014. Considering ARO stock lost 30% in 2013, there’s plenty of repair work ahead.
In recent days, rumors have been flowing that private equity is getting a sniff of its business. Aeropostale tried to sell itself once before in 2011 to no avail. This time, influential investors like Crescendo Partners, Sycamore Partners and Eminence Capital are along for the ride. Johnson’s trying to update its fashion while trimming the underperforming stores. Crescendo believes ARO shares are worth $14 to $16 (vs. current prices under $8). I totally agree.
One of two things happens in 2014: Aeropostale is sold to a strategic buyer (but more likely private equity), or Tom Johnson gets the engine restarted and it gets off the schneid.
Either way, ARO stock could be due for big gains. It’s a gamble I’d be willing to take.
Small Caps to Buy #2: Liquidity Services (LQDT)
If you’re a business or government agency, Liquidity Services (LQDT) might be who you go to in order to sell surplus assets.
Using online marketplaces, LQDT takes a cut of the proceeds. Back in 2008, I recommended LQDT stock when it was trading at $9.50.
It didn’t turn out to be the stress-free stock I thought it would be.
At the time, I had no way of knowing LQDT stock was about to go on a wild ride to $60 and beyond, then down to $20 … in a span of 36 months. 2013 was no exception as its stock lost 45%, the worst year it has had as a public company.
But consider that in 2008 when I recommended Liquidity Services, the company delivered adjusted earnings per share of 51 cents, meaning its price-to-earnings ratio at the time of my pick was almost 19. In 2013, its adjusted EPS were $1.75 for a P/E of 12 times earnings — 37% lower than its valuation in 2008. However, its adjusted EPS is currently in the midst of a walk down from $1.86 in fiscal 2012 to $1.75 in 2013 and estimated in 2014 to be anywhere from $1.76 to $1.60. At the very low end, we’re currently talking about a forward P/E of 13.5 — still much lower than back then.
Do I think LQDT will hit $60 again? Not without several years of demonstrable growth in earnings. But a 20%-30% run in 2014 isn’t out of the question should it produce better-than-expected results.
At the end of the day, Liquidity Services is a business whose need is an ongoing one. With no debt and lots of cash, I like LQDT’s chances.
Small Caps to Buy #3: Central Garden & Pet (CENTA)
In addition to its stock dropping 36% in 2013, Central Garden & Pet (CENTA) has underperformed the S&P 500 by almost 18 percentage points during the past five years while everyone and their dog — small caps, large caps, whatever — has seen impressive gains over that same period.
Central’s entire board and management team should be thoroughly embarrassed, especially chairman and founder William Brown, who owns 58% of voting CENTA stock.
CENTA is an amalgam of garden and pet products, none of which seem to make money. Five years ago, CENTA had operating profits of $126 million on $1.6 billion in revenue; in fiscal 2013, its revenues were slightly higher over 2009, but its operating profit of $40 million was 68% lower. Instead of increasing profits every year, it’s shrinking them.
At this point, you should be wondering why I’ve picked this turkey to turnaround in 2014.
I’d like to tell you it’s because Central Garden & Pet has a new product that’s selling crazy, but that’s just not the case. No, in its Q4 earnings release Dec. 10, CEO John Ranelli had this to say:
“Our financial results are simply unacceptable. While we will see some improvements along the way, it is going to take another year or two to get our performance consistently where we want it to be.”
While not very encouraging in the near-term, I feel as though any positive news from CENTA later in the year could spark a big rally in its stock price.
In my mind, this five-year nightmare has been completely factored into to its stock price, which hasn’t traded this low ($6.42 today) since early 2009, and then only because of the market crash in late 2008. The pet business is the key to CENTA’s success. If management want to solve the problem permanently, it will sell its garden business and focus on the one that’s worth saving.
If that news were to come out, you’d be almost guaranteed a doubler overnight.
As of this writing, Will Ashworth did not hold a position in any of the aforementioned securities.