20 companies screened for quality in a cheap part of the stock market

By Philip van Doorn

A two-part screen highlights small-cap companies with high returns on invested capital that also have projected growth rates for sales and profits exceeding those for the S&P 600 Small Cap Index.

Small-cap and midcap U.S. stocks are trading relatively low to historical price-to-earnings valuations, in contrast to the large-cap S&P 500. Below is a screen of the S&P 600 Small Cap Index to identify quality companies that have achieved strong returns on invested capital and are expected to boost revenue and profits relatively quickly through 2025.

This is the latest in a series of articles highlighting ways to diversify beyond the S&P 500 SPX.

Previous articles in this series:

Eight stock picks in AI, obesity drugs, e-commerce and other growth areas beyond the S&P 500This fund has outperformed with stocks that are ripe targets for other companiesThis quality approach to a cheap part of the stock market garners a five-star ratingThis ETF is beating the S&P 500 - and it's completely different from the index

Here is a comparison of current forward price-to-earnings valuations for the S&P 500, the S&P MidCap 400 Index MID and the S&P 600 Small Cap 600 Index SML:

   Sector or Index      Forward P/E  Current P/E to 5-year average  Current P/E to 10-year average  Current P/E to 15-year average 
   S&P 500                     19.8                           102%                            109%                            121% 
   S&P Mid Cap 400             14.8                            97%                             95%                             98% 
   S&P Small Cap 600           13.6                            93%                             90%                             93% 
                                                                                                                   Source: FactSet 

The P/E ratios are based on rolling weighted consensus earnings-per-share estimates among analysts polled by FactSet.

Based on valuations for the three indexes, the small-cap stocks are the least expensive on a forward P/E basis. They and the midcap group are trading below the three long-term averages, while the S&P 500 is trading higher.

For many investors, the go-to index for small-cap stocks is the Russell 2000 Index RUT. But the Russell has no selection criteria - it is simply made up of the 2000 companies with the lowest market capitalizations among the Russell 3000 Index RUA, which itself is designed to capture 98% of the U.S. stock market, also with no selection criteria.

The requirements for initial inclusion the S&P Small Cap 600 include four quarters of consecutive profits.

Since the Russell 2000 Index has no such requirement, an investor might consider it to be something of a cop-out for an active manager of a small-cap fund to benchmark against the Russell. Then again, when asked, several of these managers have said they had to do this because it is what investors demand.

Here's a comparison of performance for exchange-traded funds that track the S&P Small Cap 600 Index and the Russell 2000 Index for several periods through Monday:

   ETF                              Ticker   1-year return  3-year return  5-year return  10-year return  15-year return  20-year return 
   iShares Core S&P Small Cap ETF    IJR                0%             0%            43%            120%            516%            458% 
   iShares Russell 2000 ETF          IWM               -8%            -8%            34%             95%            413%            331% 
                                                                                                                         Source: FactSet 

And here are average returns:

   ETF                              Ticker   3-year avg. annual return  5-year avg. annual return  10-year avg. annual return  15-year avg. annual return  20-year avg. annual return 
   iShares Core S&P Small Cap ETF    IJR                          0.0%                       7.4%                        8.2%                       12.9%                        9.0% 
   iShares Russell 2000 ETF          IWM                         -2.9%                       6.1%                        6.9%                       11.5%                        7.6% 
                                                                                                                                                                      Source: FactSet 

The narrower approach of tracking the S&P Small Cap 600 Index has outperformed one tracking the Russell 2000 consistently.

Screening the S&P Small Cap 600

To screen the S&P Small Cap 600 for quality, we looked ahead at consensus estimates for revenue and earnings per share (EPS) though 2025. Then we looked back at five-year average returns on invested capital.

For the entire S&P Small Cap 600, FactSet projects a weighted compound annual growth rate (CAGR) of 3.4% for revenue and 11.8% for EPS, from 2023 through 2025.

A company's return on invested capital (ROIC) is its profit divided by the sum of the carrying value of its common stock, preferred stock, long-term debt and capitalized lease obligations. FactSet's quarterly ROIC calculation for a company is actually a 12-month look back. For five-year average ROIC, we looked at the numbers for the most recent quarter, then four quarters previous, and so on, to average the five most recent available four-quarter periods.

ROIC indicates how efficiently a company's management team has allocated investors' capital. It isn't necessarily a fair way to compare companies across industries, because some industries are more capital intensive than others. Then again, an investor has no need to be fair when selecting stocks.

Digging further into ROIC, the carrying value of a company's stock may be much lower than its current market capitalization. The company may have issued most of its shares many years ago at a price much lower than the current price. If a company has issued a relatively large amount of newer shares recently, or at high prices, its ROIC will be lower. If a company has low debt, its ROIC is higher. If a company is being forced to increase borrowings, especially when interest rates are high, its ROIC will go down.

Apple Inc. (AAPL) is an example of a very large company with a high ROIC, reflecting a significant and steady decline in its share count as it has bought back shares, along with strong cash flow. The company's five-year average ROIC has been 48.4%. But Apple would not pass the screen for this article, as its projected two-year sales CAGR through calendar 2025 is 4.1% and its expected two-year EPS CAGR through 2025 is 8.1%. For the S&P 500, the expected two-year CAGR through 2025 are 4.4% for sales and 12.4% for EPS. Despite the long-term quality, maybe the notion that Apple is now a slow-growth company has helped push its stock down 14% this year (with dividends reinvested).

So the idea of this screen was to highlight long-term quality for smaller companies that are expected to grow their businesses through 2025 at least slightly more quickly than projections for the S&P Small Cap 600 Index.

The screen

Here's how we narrowed down the list of stocks:

Among the S&P Small Cap 600, there were 348 companies covered by at least five analysts polled by FactSet, for which estimates were available through 2025 and for which data were available to calculate five-year average ROIC. We removed any for which EPS were negative or estimated to be negative for 2023, and any for which consensus 2024 or 2025 EPS estimates were negative. This brought the screen down to 292 companies.Among the 292 companies, there were 171 for which projected revenue CAGR from 2023 through 2025 exceeded the expected growth rate of 3.4% for the index.Among those 171 companies, there were 81 companies for which projected EPS CAGR from 2023 through 2025 exceeded the expected growth rate of 11.8% for the index.

We used calendar-year estimates for sales and EPS as adjusted by FactSet for a uniform set of data, because some companies' fiscal years don't match the calendar. We also removed any company for which 2023 EPS (or estimated EPS) were negative.

At this point we sorted the remaining 81 companies by five-year average ROIC.

Here are the 20 with the highest five-year average ROIC - for comparison, the weighted average ROIC for the full S&P 600 has been 4.74%, according to FactSet.

   Company                              Ticker   Five-year average ROIC  5-year min ROIC  5-year max ROIC  Two-year estimated sales CAGR through 2025  Two-year estimated EPS CAGR through 2025 
   PJT Partners Inc. Class A             PJT                      37.1%            19.6%            47.7%                                       10.7%                                     21.7% 
   Catalyst Pharmaceuticals Inc.         CPRX                     35.5%            20.5%            58.2%                                       17.4%                                     57.1% 
   California Resources Corp.            CRC                      26.4%            -0.6%            59.8%                                       13.6%                                     14.8% 
   Corcept Therapeutics Incorporated.    CORT                     24.3%            20.9%            29.0%                                       17.5%                                     16.6% 
   Kulicke & Soffa Industries Inc.       KLIC                     17.3%             2.1%            43.7%                                       13.9%                                     22.7% 
   Badger Meter Inc.                     BMI                      16.2%            14.2%            20.4%                                       12.0%                                     19.7% 
   LGI Homes Inc.                        LGIH                     14.9%             6.8%            22.1%                                       18.8%                                     18.6% 

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