The US stock market has produced some heady returns so far this year, and one classification that should not be overlooked is small cap stocks. Typically categorized as those companies with a market capitalization between $300 million and $2 billion, small caps are an important part of a diversified portfolio.
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And as Business Insider reported earlier this week, US small caps have been outperforming the already strong US markets. The Russell 200 index, a small cap index fund, has returned 22% in the year to date compared to 19% for the S&P 500.
Small cap stocks tend to rely on domestic sales more so than their larger competitors who branch into foreign markets. With US GDP growth expected to increase from 1.5% this year to roughly 3% into 2016, small caps may benefit further from increasing domestic productivity and consumption.With this in mind, we ran a screen among US small cap stocks for signs of undervaluation, as well as positive inventory trends. First we looked for small caps that appear undervalued relative to their cash flows, indicated by high ratios of levered free cash flow/enterprise value (LFCF/EV). Levered free cash flow is the what remains after deducting interest payments on outstanding debt. Enterprise value is the sum of the firm's value from all ownership sources: market cap, outstanding debt, and preferred shares. When companies have ratios of LFCF/EV in excess of 10%, it may indicate that the company as a whole is being undervalued. Next we limited our results to those with positive trends in inventory, namely stocks with growth in quarterly revenue greater than growth in quarterly inventory. Since inventory represents the portion of goods not yet sold, faster growth in revenue than inventory is considered an encouraging sign. This may indicate that the company is selling its inventory more readily than in the past – although this might just be a reflection of a change in sales strategies.