Small-cap stocks are hot at the moment. The S&P SmallCap 600 index has rallied more than 18% in just the last month. After falling more than 40% into March lows, the index now is positive year to date.
It’s not terribly difficult to see why. Small-cap stocks generally are higher-risk and higher-reward, and investors are focusing more on the rewards. With the economy performing better than feared, and hopes for a novel coronavirus vaccine, optimism reigns at the moment.
But that itself is dangerous. As Thomas Ruchti, Assistant Professor of Accounting at the Tepper School of Business, Carnegie Mellon University, told InvestorPlace:
“In more recent research [about small-cap stocks], Baker and Wurgler (2006) identified a role that sentiment plays in mitigating the returns of this factor. If market sentiment is low, returns to investing in small stocks will be high in the future because these smaller stocks are relatively ignored, especially by retail investors.
“If market sentiment is high, well, the returns to investing in small stocks will be smaller because retail investors are less likely to have ignored them in the first place. Two years ago, sentiment was moderately low, but from what I can see, market sentiment is relatively high right now. That has historically meant significant headwinds for any investment strategy trying to load up on the risks (and returns) of small-cap stocks. There are a lot of investors crowding into the chase for yield right now; that does not always end well.”
If small-cap stocks as a whole look risky right now, these eight names look downright dangerous. To at least some extent, all eight stocks have participated in the recent rally. Yet the outlook for these names remains cloudy — at best.
Small-cap stocks as a whole may continue to rally, but these stocks are likely to underperform:
- Aurora Cannabis (NYSE:ACB)
- Seritage Growth Properties (NYSE:SRG)
- Designer Brands (NYSE:DBI)
- Deluxe Corporation (NYSE:DLX)
- Groupon (NASDAQ:GRPN)
- AMC Entertainment (NYSE:AMC)
- ScanSource (NASDAQ:SCSC)
- MSG Networks (NYSE:MSGN)
Small-Cap Stocks to Watch: Aurora Cannabis (ACB)
Cannabis stocks have posted a long-awaited rally in the last few weeks. What was basically a clean sweep in state-level elections and referendums, along with the looming presidency of Joe Biden, suggests U.S. legalization at the federal level may be a near-term possibility.
In that context, the rally makes sense. But it’s not at all clear that Aurora stock should be taking part. The company has minimal exposure to the U.S., even assuming federal legalization. A stretched balance sheet is forcing the company to slash costs, and would limit its ability to aggressively tackle a federally legalized market.
Meanwhile, Canopy Growth (NASDAQ:CGC) has plenty of cash and a potentially transformative agreement with Acreage Holdings (OTCMKTS:ACRHF). Other rivals have opportunities as well. ACB stock had been headed in the wrong direction before the recent rally, and it’s likely to resume its decline in relatively short order.
Seritage Growth Properties (SRG)
Seritage Growth Properties was spun out of Sears Holdings (OTCMKTS:SHLDQ) back in 2015, as a way to capture some value from the former parent’s real estate. And SRG stock had an interesting bull case post-spin. Sears’ real estate presumably was more valuable with a different concept occupying it, and it was Seritage that had the ability to recapture that real estate and re-lease it at higher rates. Warren Buffett certainly liked that bull case; his Berkshire Hathaway (NYSE:BRK.A, NYSE:BRK.B) bought SRG stock back in 2016.
The bull case, however, remained more attractive on paper than in practice. Seritage did post some growth, but SRG stock remained dead money until the pandemic struck. Even with a decent rally from March lows, SRG stock is still down 55% year-to-date.
It’s hard to see how SRG can climb much higher. Retailers have done reasonably well post-pandemic, admittedly. But they’ve generally benefited from online sales and cost-cutting, neither of which bodes well for retail real estate more broadly. Seritage’s big-box spaces seem particularly ill-suited to the new normal.
A 5.6% dividend yield could attract income-seekers, and it’s possible Seritage carves out a new niche. But it seems investors at the least have far better ways to play a post-pandemic rebound in brick-and-mortar retail.
Designer Brands (DBI)
Again, some retailers have managed to pivot quickly amid store closures and “stay at home” orders. Indeed, stocks like Gap (NYSE:GPS) and American Eagle (NYSE:AEO), to name just two, are in the black YTD.
Designer Brands, which operates primarily under the DSW Designer Shoe Warehouse nameplate, hasn’t been quite as nimble. Sales in the fiscal second quarter plunged 43% year-over-year. Adjusted gross margin was barely 8% of revenue, against more than 30% the year before.
There are two core problems for Designer Brands. First, DSW has a relatively small e-commerce business, which limited its ability to maintain revenue during the worst of the pandemic. It also minimizes DBI’s ability to join the e-commerce trend that has accelerated so far in 2020.
Second, the company’s focus traditionally has been more in categories like loafers than in sneakers. In an environment where remote work is likely to pick up, those categories are going to shrink, rather than grow.
DBI stock has posted a sharp rally of late, nearly doubling in a little over a month. But barring a blowout fiscal Q3 release next week, the gains seem more like a “dead cat bounce” than the start of something bigger.
Deluxe Corporation (DLX)
If DLX bulls are right, the rest of the market is wrong. In stocks like PayPal (NASDAQ:PYPL) and Square (NYSE:SQ) and even bitcoin, the market is pricing in an accelerated shift to digital payments in the wake of the pandemic. That shift represents a significant threat to Deluxe’s business.
After all, Deluxe still manufactures many of the paper checks used in the U.S. Those checks drove 39% of 2019 revenue. Elsewhere, marketing materials sales face pressure from growing digital advertising. E-signatures from DocuSign (NASDAQ:DOCU) and Adobe (NASDAQ:ADBE) can take the place of Deluxe’s printed business forms.
Admittedly, those stocks all look relatively expensive. And it’s possible the market is pricing in a faster shift than may take place. If that’s the case, DLX, at less than 6x forward earnings, could prove to be a buy.
But betting on a declining business has been dangerous for years now. And even if the market is too optimistic elsewhere, it doesn’t mean it’s too pessimistic when it comes to Deluxe.
It’s tempting, perhaps, to view Groupon as a pandemic victim that could be a strong play on a return to normalcy. After all, many current and potential Groupon customers — restaurants, nail salons and the like — have faced significant hardships this year. But a vaccine could lead those business to see strong rebounds in 2021, which in turn would drive higher revenue and profits for Groupon as well.
But GRPN stock was struggling before the pandemic hit. It entered 2020 just off an all-time low. And that’s because the core problem with Groupon is structural: its business model simply doesn’t seem to work. Groupon pitches itself as a marketing partner, but skeptics long have argued the company is actually a lender, and one with a high effective interest rate. Groupon customers get a burst of upfront cash from Groupon sales, and then must pay back that cash over time by providing goods or services with a face value that is multiples of the cash raised.
At this point, it’s impossible to dismiss the skeptics (and I’ve long been one myself). Groupon has never been able to drive consistent profit, owing in large part to stubbornly high selling expenses. Those expenses are driven by the constant need to find new businesses who haven’t yet been burned by Groupon.
The pandemic has exacerbated those problems, but it obviously didn’t create them. Until Groupon somehow finds a solution, any rally in GRPN stock will be short-lived.
AMC Entertainment (AMC)
Movie theater operator AMC is another return to normalcy play whose bull case falls apart under closer scrutiny. The pandemic certainly has crushed AMC’s business: revenue declined 98.7% year-over-year in the second quarter to just $19 million.
But AMC, too, was struggling long before the pandemic. By tickets sold, movie theater attendance peaked in 2002. The shift to higher ticket prices and better amenities has helped somewhat, but also has required significant capital that has led to a dangerously leveraged balance sheet.
Indeed, AMC was at risk of bankruptcy even before the pandemic. The risk certainly isn’t any lower now, and the hopes for growth seem dim. It’s just too much to expect a rebound here.
ScanSource is a decent company, but it has two strikes against it at this point. First, the company is a distributor at a time when many middlemen are being disintermediated by technology. Second, its core business is in networking, an end market that has struggled for some years now.
These problems aren’t new. SCSC stock in fact has declined 16% over the past decade, while the Nasdaq has rallied almost 400%. And while the stock is cheap at less than 10x forward earnings, networking manufacturers aren’t much more expensive. If an investor wants to bet on the category, it seems worth paying a modest premium for Cisco Systems (NASDAQ:CSCO) or Juniper Networks (NYSE:JNPR). ScanSource’s path seems just too tough.
MSG Networks (MSGN)
After touching an all-time low early last month, MSGN stock has roared back to life over the past few weeks. It’s hard to judge a specific driver of the 50%-plus rally, beyond the general optimism toward small-cap stocks.
It’s also hard to see the rally continuing. MSGN seems to be a play on live sports, given the company’s broadcasting deals with the New York Knicks, New York Rangers and other sports teams. But in fact, MSGN is a play on cable subscribers. Roughly 90% of revenue comes from so-called affiliation fees, payments from cable and satellite operators for the right to carry MSG Network.
Of course, that makes MSG Networks an obvious victim of cord-cutting. Indeed, subscriber numbers keep falling, including an 8.5% decline in the most recent quarter. Advertising revenue growth, even assuming the Knicks or Rangers could somehow return to relevance, is not nearly enough to offset those problems. MSG is not going to be able to keep charging ever-higher per-subscriber rates, yet its deals with the Knicks and Rangers both include annual escalators.
Tack on a reasonable amount of debt and MSGN looks like a classic value trap. A month ago, the market seemed aware of that fact. It’s unclear why it has changed its mind, but it’s likely to do so again.
On the date of publication, Vince Martin did not have (either directly or indirectly) any positions in the securities mentioned in this article.
After spending time at a retail brokerage, Vince Martin has covered the financial industry for close to a decade for InvestorPlace.com and other outlets.