Small caps have had it a little rough this year. After surging in 2012 and 2013, the small cap Russell 2000 index has fallen more than -4% so far this year and is down over -8% from its all-time high. This is despite large cap indexes like the S&P 500 and the Dow Jones Industrial Average holding steady through most of the year and even recently hitting new all-time highs.
There are many possible explanations for this “risk-off” move by investors. Fed tapering. Geopolitical uncertainty. Global economic growth concerns.
There is also the possibility that some of these stocks simply got too far ahead of their fundamentals, and now the market is reassessing their valuations. This could explain why value stocks have held up much better than their growth counterparts within the small cap space.
Focus on the Fundamentals
It looks like gains are going to be much harder to come by going forward than they were in the recent past, particularly for small cap stocks. If investors want to have success in this market environment, they need to pay close attention to the fundamentals.
Things like valuation, earnings momentum, cash flow and balance sheet strength – which were all but ignored last year – are becoming important to the market again.
With this in mind, I ran a screen in Research Wizard looking for small cap stocks with strong fundamentals, including:
- Reasonable price-to-earnings and price-to-cash flow ratios,
- Solid earnings momentum, with a Zacks Rank of 1 (Strong Buy), 2 (Buy) or 3 (Hold),
- Strong balance sheets with low debt levels and healthy liquidity ratios,
- Attractive returns on invested capital, and
- Year-to-date returns greater than the S&P 500.