Overlooked opportunities: How to profit from small and medium-sized company stocks
The slowdown of inflation in the US is boosting the attractiveness of investing in small and mid-cap mid-cap companies in the American market. Despite their valuations being incomparable to market leaders, such companies offer huge opportunities for investors.
Recent data from the US Department of Labor has encouraged investors: job growth in April was weaker than expected, and wages did not increase by more than 4% for the first time in 3 years. This trend signals a slowdown in inflation. Although the labor market remains tight, analysts are indicating a higher probability of a Federal Reserve rate cut in September 2024. Following the release of Labor Department statistics, investment banks raised the probability of two rate cuts by the end of this year from 52% to 68%, according to CME Group data cited by The Wall Street Journal.
The reduction of the US Federal Reserve’s key interest rate is essential for many sectors of the economy. However, it was particularly anticipated by small and micro-cap companies, which investment banking analysts predicted would experience a rally due to their undervaluation as early as the beginning of 2024.
Small companies are usually more vulnerable to inflation because they are more sensitive to rising production costs and expenses and find it harder to cut costs or change their business models. Additionally, a significant portion of their loans are short-term, and refinancing comes with higher rates. What prospects can small-cap companies now offer investors, and how can one profit from them?
Is there life below the S&P 500?
The American stock market is structurally divided into six groups based on company capitalization. The largest are “mega-cap” companies with a capitalization of over $200 billion. Next are “large-cap” companies, whose capitalization ranges from $10 billion to $200 billion. “Mid-cap” ranges from $2 billion to $10 billion; “small-cap” from $250 million to $2 billion; “micro-cap” companies range from $50 million to $250 million; and at the end of the list are “nano-cap” players with a capitalization of less than $50 million.
There are several major indices based on the capitalization of small-cap companies, such as the S&P 600 Small Cap and the Russell 2000. Globally (largely represented by American companies), there are several micro-cap indices, including the Russell Microcap Index, LD Micro Index, Dow Jones U.S. Micro-Cap Total Stock Market Index, and MSCI USA Micro Cap Index.
Typically, micro-cap indices consist of between 1100 and 1600 companies. The Russell Microcap Index has the highest median capitalization at $237 million, followed by the LD Micro Index at $137 million, and the MSCI USA Micro Cap Index at $104 million in third place. The lowest corresponding value is found in the Dow Jones U.S. Micro-Cap Index at $71 million.
The similarity in industry breakdown among participating companies suggests that all four indices generally cover the same group of micro-cap companies: approximately 40 to 50% are in two sectors, healthcare, and finance, albeit in varying proportions. Sectors such as minerals, technology, manufacturing, and consumer goods are represented to a lesser extent, ranging from 8 to 17%.
As of April 2024, the LD Micro Index comprises 1188 active member companies with a total market capitalization of $177 billion. Objectively, these figures are incomparable to the total value and median capitalization of the top 500+ largest companies on the American stock market, which were $40 trillion and $35 billion, respectively, in 2024 (255 times higher than in the LD Micro Index). Nevertheless, these companies can be profitable investment targets with a well-considered investment strategy.
These opportunities were highlighted at the 14th annual LD Micro Conference held in New York on April 8-9, 2024. Eighty innovative small and mid-cap American companies showcased their businesses to investors and journalists at the event.
What are the key characteristics of small-cap company stocks? Typically, their securities are more volatile and, hence, riskier compared to stocks of larger companies, but they also have the potential to grow much faster.
Vadim Merkulov, Director of the Analytical Department at Freedom Holding Corp. (FRHC), observes that currently, investor interest in small- and micro-cap companies is relatively low due to high debt burdens and elevated interest rates:
“We observe better dynamics in the S&P 500 compared to small and micro-cap companies. Of course, this doesn’t apply universally; there are intriguing stories. Overall, I would offer a cautiously optimistic outlook for them. Once conditions improve for small businesses, with lower rates and a robust economy, these companies could outperform the S&P 500. The last time small companies outpaced the market was over a decade ago; now, there’s accumulated growth potential, and these companies are undervalued. This presents an opportunity for investors.”
An important aspect is that small-cap companies often propose bold development programs, which can significantly enhance their fundamental economic indicators and increase their market value swiftly. Market impacts for such companies manifest much more quickly, making it crucial for investors to closely monitor their plans and concepts.
At the LD Micro conference, representatives from telecommunications firm Crexendo (CXDO), information solutions developer Inuvo Inc. (INUV), payment industry player IDT Corporation (IDT), and numerous others delivered presentations.
Another promising entity is DocGo, which specializes in medical services like vaccine deployment and patient transport via electric ambulance. Additionally, DocGo is developing IT solutions to help institutions accurately assess real-time medical staffing needs.
The wide variety of options allows investors to find completely different investment strategies. Mid-cap and small-cap companies are very diverse, as are the markets they operate in. It is not necessary to chase innovation or breakthrough developments.
«There are more stable stories that might seem boring at first glance. For example, Acme United Corporation’s primary business is selling scissors. They cost 60-70 cents to produce and are sold to distributors for $2.50, which is four times the cost. On Amazon, they sell for $10. It’s an interesting business that generates a huge cash flow. They earn most of their revenue from industrial first aid kits and are currently actively expanding globally,» says Merkulov.
Kazakh technologies for the USA
The problem is that it’s challenging for an average investor to analyze small public companies. Unlike S&P 500 companies, these firms do not receive constant attention from analytical structures, so investors often have to do much of the groundwork themselves. As Kursiv has previously reported, another «inherent» drawback of such companies is their limited liquidity. It is not easy for an investor to quickly buy or sell shares of a promising small company.
However, brokers see the objective issues with analytics and liquidity as an opportunity for business development. In his speech to European journalists at the LD Micro conference, Timur Turlov, CEO of Freedom Holding Corp. (FRHC), noted that the niche for providing highly qualified institutional research services to companies outside the S&P 500 index is not yet fully occupied in the American stock market.
“I think we are talking about 2,000 public companies in the USA that are much less covered by research compared to the key blue chips. Thanks to our strong analytical team in Kazakhstan, we can make a significant contribution to the development of our office in the USA by refining our research conducted abroad. Finally, a strong team here in the USA will be able to make this research accessible to the market and even create a community together with small-cap companies that will be very interested in this research, as well as in some other corporate services,” said Timur Turlov.
Turlov believes that FRHC will gain a unique advantage by offering small and micro-cap American companies high-quality and affordable research and consistent access to liquidity.
“This will also give small American companies access to retail investors from Central Asia and possibly Europe. We are heavily involved in IT and software development in Kazakhstan and Europe—for example, the trading platform Tradernet (Freedom 24), which provides direct access to various exchanges in the USA, Europe, and Asia. I hope we can realize the potential of this retail IT platform, which can compete on equal footing with Robinhood and other similar solutions, and perhaps we will find a partner who will use our software,” added Turlov, answering questions from European journalists at the historic Trump Tower on Wall Street in New York.
According to Turlov, creating another platform similar to Tradernet in the USA would be extremely expensive due to the inflated cost of living and high salaries; it would take hundreds of millions of dollars.
“We have already invested tens of millions of dollars in Kazakhstan, where the cost of production is much lower. I am confident this will open up unique opportunities for us to grow our business in the USA. In Kazakhstan, we are testing our extensive digital ecosystem to better understand how different business directions can contribute to mutual growth and how to use machine learning technologies for more efficient data collection. We have a huge amount of data processed by our algorithms. I think we will conduct an interesting study in Kazakhstan and gain a better understanding of how we can benefit from partnerships between various lifestyle and financial services. We will enter the US and European markets, possibly not to buy companies, but to partner with them,” said Timur Turlov.
