Spotting Tomorrow’s Winners Today

First there was FANG.

Then there was FAANG.

No matter what acronym you prefer or what it will eventually become, much of the noise on Wall Street is centered on the world’s largest companies – Facebook (FB), Amazon (AMZN), Apple (AAPL), Netflix (NFLX) and Alphabet (GOOGL). But here’s the thing: When you remove those stocks and some other big tech names from the equation, you get a very different picture.

The fact is that a majority of large-cap companies are struggling to keep their heads above water. Roughly half of the stocks in the S&P 500 are negative so far in 2018, and more than a third are down 5% or more. One phenomenon we’ve seen the last few months is a huge disconnect between the winners and stragglers, and I suspect that trend will continue.

I can’t say that I never invest in Wall Street’s big names – I do, but only when they meet my strict NexGen criteria and prove to me they have what it takes to be just leaders not just today but months and years into the future. That said, I’m much more interested in investing in stocks that aren’t quite as well-known right now yet are on a path to become some of Wall Street’s biggest names in the future. That’s where the real money is made.

Finding those stocks means digging beneath the surface and uncovering companies that Wall Street hasn’t even heard of or simply isn’t focused on yet. These are invariably small caps, which is an area that has been showing a lot of strength recently. Because many of tomorrow’s leaders are today’s small names, I believe their strength is actually more important to the long-term health of the overall market.

The Little Guys are Outperforming

The Russell 2000 (RUT) consists of small-cap stocks and is probably the best gauge of how they are doing overall. The index is currently up nearly 6% so far in 2018 while the S&P 500 has gained just 1.3%. That puts the small guys ahead of the big kids by a margin of more than 4-1. The chart below shows this comparison, with the black line being the small caps and the orange line being the S&P.

This is significant because large-cap stocks have outperformed their smaller peers three of the last four years. Last year was particularly striking as the S&P raked in profits of 21.8% while the Russell increased 14.7%.

But over time, history shows you can make more money in small caps – if you invest in them the right way. Over the last 15 years, the Russell 2000 has returned 11.2% per year on average versus 10.2% for the S&P 500. The Russell’s best year in that span saw a 47.3% return, which blew away S&P’s best year at 32.4%. Believe it or not, the worst year for the Russell – a 33.8% decline – was less than the S&P 500’s worst year at -37%.

As small caps have strengthened, they’ve been the first to get back to all-time highs. The S&P 600 Small Cap Index was officially the first to recapture record territory, and the Russell 2000 has also accomplished that feat. The large-cap indices have been performing better recently, but all still remain several percentage points below their all-time highs.

Only the Beginning

Small caps have been helped by a number of things, the first of which is the tax reform that went into effect at the beginning of this year. The changes were a major boost to these companies since their effective tax rates were higher than those of larger firms (which could get more creative with their accounting thanks to a payroll filled with lawyers and accountants to take advantage of corporate tax loopholes).

Then there’s the rise in the U.S. dollar, which makes exports more expensive in other countries. Large multinationals that derive the majority of their sales overseas can be hurt by a stronger dollar, but the smaller companies that do most of their sales within the United States don’t face those headwinds.

The stronger U.S. economy has also played a large role in boosting the small caps. As demand for domestic goods and services increases, more money flows back into the country and many of the smaller companies we follow.

And with a strong U.S. economy comes higher interest rates, and we are now in the midst of a Fed hike cycle that is expected to continue to a couple more years. During the last four rate hike cycles, the small caps outperformed their larger peers 75% of the time and averaged a gain of 18.7% versus the S&P 500’s 17.2%. I’ll admit that difference isn’t huge, but it still helps boost my bullish view here.

Most importantly to us as investors, some of these small caps will go on to become large caps. Getting in early and going along for a lot of that ride is a great way to build wealth. Remember, even the FAANG stocks were small companies at one point in time.

Of course, a lot more smaller companies won’t make it at all, so you have to make sure you know what you’re doing when investing in them. I’ll share some of my analytical techniques – and maybe even a little secret or two – in a future article.

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