4 Undervalued Small-Cap Stocks to Buy

Susan Dziubinski: I’m Susan Dziubinski with Morningstar. Every Monday morning, I sit down with Morningstar chief U.S. market strategist Dave Sekera to discuss one thing that’s on his radar this week, one new piece of Morningstar research, and a few stock picks or pans for the week ahead.

On your radar this week, Dave, is the Consumer Price Index. The January CPI number comes out Tuesday. What’s the expectation there, and what might it mean for the market this week?

Dave Sekera: Good morning, Susan. Well, we’ve got earning season starting to wind down. We still have a number of companies reporting this week. But following on Fed Chair Powell’s comments last week, I suspect the market is going to start shifting its focus pretty soon and start being more focused on economic and inflationary indicators. And as you mentioned, this week, we do have the CPI number coming out for January. I think considering the Fed’s ongoing focus on inflation, I think the market’s going to watch this number very closely this week. And I do think this could drive some short-term volatility. So, if the reading is lower than expected, I think the market would then expect the Fed may not have to raise the federal-funds rate as much as I think the market is pricing in right now. It may not have to keep monetary policy as restrictive for as long. However, if that reading is higher than expected, I think the market then may change course, it may end up pricing in an even higher federal-funds rate, and then it may end up being higher for longer.

Dziubinski: You did mention Powell’s appearance before the Economic Club of Washington last week. He acknowledged that inflation is slowing, but that it’ll be a long process to bring that inflation number down to the Fed’s 2% target. What did you make of Powell’s comments last week, and what’s your take on interest rates this year?

Sekera: I think the takeaway is that the Fed, and specifically he mentioned this several times in his commentary, both at the press conference after the FOMC meeting and in the Washington, D.C.,, Economic Club for growth, the Fed’s in very early stages of disinflation at this point. Now, I do think they are starting to shift their stance a little bit and they’re going back toward balancing their dual mandate. And of course, that includes maximizing full employment, as well as keeping inflation low. But for now, the Fed is still very focused on tightening monetary policy enough in order to bring inflation down.

Some of the things that I heard from Chair Powell is that whenever he did talk about interest-rate increases he always used the plural form. So, I think that indicates he suspects that there’s at least two more interest-rate increases yet to come. And he is very emphatic in that he thinks we’re still in “very early stages of disinflation.” And I think he reported that several different times. He noted that while inflation for goods has declined, inflation for services still remains high. And specifically, he highlighted that he’ll need to see deflation and core services ex-housing before he starts to get comfortable that we really are on a downward trend for inflation.

And then, lastly, the other thing that caught my ear is he made the remark that he thinks it’s going to take well into next year to get inflation close to that 2% target that the Fed has.

Dziubinski: What are the takeaways then for investors, Dave? How should they be thinking about their investments today against that backdrop?

Sekera: Well, we’ve had an extremely strong beginning of the year. In fact, the Morningstar US Market Index is up about 7% year to date. And according to an aggregate of the fair values of the stocks that we cover, we think the market still remains about 8% to 9% undervalued. However, I suspect that markets will be volatile over the next couple of months. And specifically, we do expect that the economy’s going to be stagnant even to recessionary in the first half of this year. That would then put earnings growth under pressure for the first quarter and the second quarter. So, I think investors should mentally prepare themselves for about volatility, which may last up until early spring, maybe even into early summer. That’s the point in time that I think leading economic indicators will probably start to turn up. Now, I think for investors that have the appropriate risk tolerance, they can use these pullbacks to tactically increase their equity exposure and then use any subsequent rallies to lock in gains and reduce their exposure back to their long-term allocation goals for equities.

Dziubinski: Let’s move on and talk a little bit about some new research from Morningstar. In last week’s episode, we talked a little bit about your latest market update report, and we focused then our conversation on growth stocks so far this year. So this week, let’s look at the market through the lens of market capitalization. Small-cap stocks have outperformed large-cap stocks this year. What’s driving that outperformance?

Sekera: That Morningstar US Small Cap Index is up almost 10% year to date, so, well in excess of what we’ve seen you across the broader market, and I think it’s a combination of a couple of different things. So, first, that tax-loss selling pressure that we saw in December is now behind us. But also you have to remember too that small caps, they significantly underperformed the broader market in 2020 and 2021 during the pandemic. And I think there were a couple of things there. One, investors were concerned about the liquidity and credit worthiness of many of these small-cap companies and just their ability to survive the pandemic themselves. Plus in the small-cap space, they lagged the earnings growth that we saw in a large-cap space, especially those large-cap companies. When you think about those that benefited from the economic and societal changes that were brought about by the pandemic. So looking forward, I think the market is really just responding to a combination of, one, just the general level of undervaluation in the small-cap space, along with the expectation that earnings growth will normalize and begin to reaccelerate among small caps.

Dziubinski: Dave, do you expect this small-cap stock outperformance to continue?

Sekera: Well, it’s always hard to tell. As you know, we are investors and not traders. In the short-term, I wouldn’t necessarily make any bets one way or the other, but I would say this is the area that we see the most undervaluation. And so, while we don’t try and predict short-term movements in the market, we do look to position ourselves for long-term total returns. In today’s market, I would note that the small cap does provide investors with the most margin of safety from our intrinsic valuations. And over time, we would expect to see small caps outperform the mid- and the larger caps over the next couple years.

Dziubinski: So, we do see at this point in time that small-cap stocks, even after this bit of a runup, do still look undervalued relative to larger companies?

Sekera: Exactly. Even after this outperformance year to date, small-caps are still the most undervalued by capitalization. And we break that composite of our valuations down by market capitalization, we see that small caps are trading at about a 20% discount to our fair values as compared to the broader market, which is only an 8% to 9% discount.

Dziubinski: Your stock picks this week, you brought along four undervalued small-cap stocks that you liked. Stock number one is Malibu Boats MBUU. What do you like about it?

Sekera: We currently rate Malibu with 4 stars, and we do assign the company a narrow economic moat. And it currently trades well over a 30% discount to our fair value. For those of you not familiar, Malibu makes powerboats. And as you’d suspect, boats actually sold very well during the pandemic as people were looking for outdoor activities. Now, looking forward, you do expect that Malibu will be able to maintain these elevated sales levels through a combination of market share gains, as well as entering new market segments. The company did recently report results, and margins were under pressure from inflation, but management maintained their full-year guidance. So, I suspect that the company has a couple of different plans in place in order to be able to bring their margins back up to where they were before and be able to beat off that inflationary impact.

Dziubinski: Now, your second pick this week is Macerich MAC, which operates regional malls. Why is this one a pick?

Sekera: That one’s currently rated 5 stars, and it trades about half of our fair value estimate, and it is a REIT and does pay a pretty healthy dividend. I think it’s currently about a 5% or a little over 5% dividend yield today. Now, according to our analysis, we think the prognostication that the death of the shopping mall is just greatly over-exaggerated at this point. Those that do have lower quality malls, those that would be considered to be Class B and Class C are struggling. But with Macerich, we do think that their portfolio is very high-quality, generally Class A. And we have been seeing increases in Class A mall foot traffic as the pandemic recedes.

Plus, malls have been adapting to the change in the retail environment with retailers being under pressure from growing online sales. The things they’ve been doing, they’ve looked to revise their portfolio of retailers in those malls in order to have a portfolio that drives more traffic, but they’ve also revised the malls in and of themselves to become more experiential. And so, what that means is that they’re looking to do things that can’t be replicated online. So, think about services such as restaurants or gyms or physicians’ offices. All of those have been helping to drive foot traffic. And of course, you can’t replicate that online.

Dziubinski: Now your next undervalued small-cap pick is Ingredion INGR. It’s a consumer defensive name. The company makes ingredients for the food and beverage industries among others. What do you like about it?

Sekera: Ingredion is currently a 4-star-rated stock, and it trades it a little under a 20% discount to our fair value. And I believe its dividend yield is just under 3% at this point. And we do rate the company with a narrow economic moat. One of the things I do like about this company today is that, even in this inflationary environment, Ingredion does have very strong pricing power, and I think that speaks well to the economic value of its products. So, it has been able to push through its own cost increases to their own clients. Now, looking forward, we do forecast the company will increase its sales mix into additional higher-margin specialty products, and that, in turn, will continue to drive more operating growth and more operating income growth, specifically.

Dziubinski: And then your last pick to this week is Guardant Health GH. Morningstar thinks Guardant will likely become a key player in liquid biopsy.

Sekera: Exactly. And, in fact, I would say that’s one of our better picks in what I consider to be the medtech space. So, that stock is currently rated 5 stars, and it trades a little under half of our intrinsic valuation. Now, we don’t assign that company an economic moat, but we do note that it has a positive economic moat trend. When I think about the liquid biopsy space, according to the research from our team, we think that’s one of the largest market opportunities across the entire healthcare sector going forward.

And for those of you that might not be familiar, a liquid biopsy is a noninvasive method of analyzing tumors using fluids like blood. And that really represents what we think is a potential paradigm shift in when cancer is detected and treated. I would highlight that with Guardant, we do assign a Very High uncertainty rating to that stock. It is a higher-risk situation. Now, I think the upside value of that company will come when the company starts to attain some of those FDA approvals for its liquid biopsies that are currently being tested. But like I said, being a higher-risk company, higher-risk situation, I would caution, I think, that the stock is more appropriate for those investors that do have the ability to handle that higher risk in their portfolios.

Dziubinski: Well, thanks for your time this morning, Dave. Dave and I will be off next Monday for Presidents Day. But be sure to join us again live on YouTube on Monday, Feb. 27 at 9 a.m. Eastern, 8 a.m. Central. And while you’re at it, subscribe to Morningstar’s channel. Have a great week.