When used judiciously, small-cap stocks can juice your portfolio’s long-term returns.
Morningstar.com portfolio strategist Amy Arnott discussed using small caps within a portfolio in June. The discussion was part of a series to help investors put together sound portfolios.
“In theory, smaller companies have more room to grow because they haven’t yet reached their full potential or scale. Academic research has often highlighted the long-term performance advantage of smaller-cap stocks,” Arnott wrote.
However, although they do sometimes outperform their large-cap brethren, over the past twenty years through May, annualized returns have been over five percentage points worse than those of large-cap stocks. Worse, they have been much more volatile.
So, why bother?
Small-cap stocks account for about 8% of the overall equity market, Arnott writes, so it makes sense to include a sliver of them. Further, Morningstar’s equity analysts suggest that small-cap stocks they cover are trading at a 10% discount to fair value, twice as high as large-cap stocks.
Using the holdings of the Morningstar Gold-rated DFA US Small Cap ETF (NYSEARCA:DFAS), here are three small-cap stocks to buy to help juice your portfolio’s performance.
Abercrombie & Fitch (ANF)
Abercrombie & Fitch (NYSE:ANF) is DFAS’s top holding by weight at 0.46%. The retailer has a market capitalization of $9.19 billion. Its shares are up 382% over the past year, so it started last July with a market cap at or below the $2 billion ceiling many investors give for small-cap stocks.
ANF is known for two primary brands: Abercrombie and Hollister. Secondary brands include Abercrombie Kids and Gilly Hicks. In Q1 2024, Abercrombie’s sales rose 31% to $571.5 million, while Hollister’s increased by 12% to $449.2 million. Together, they increased 22% to $1.02 billion.
What’s impressive about Abercrombie is its inventory control. Despite sales increasing 22% in the quarter, inventories were flat at $449 million year-over-year. Also, its adjusted EBITDA margin in the quarter was 16.4%, 750 basis points higher than a year ago. Because of the strong quarter, it nearly doubled its cash on its balance sheet, from $447 million in Q1 2023 to $864 million this year.
However, it’s come a long way in a short timeframe, so only three of the ten analysts covering its stock rate is a Buy.
Ignore the naysayers; it’s got a whole world to conquer.
Onto Innovation (ONTO)
One of the reasons small-caps often underperform is that they’re less tech-focused and more manufacturing-focused. However, with Onto Innovation (NYSE:ONTO), you can have your cake and eat it too. It is the second-largest holding of DFAS at 0.41%. At a market cap of $11.2 billion, it is far above the defined market cap range, but since it’s still in the ETF, it makes the list.
Onto Innovation provides state-of-the-art measurement, inspection, data analysis and lithography solutions for semiconductor manufacturing and advanced packaging processes. Their solutions help its customers get products to market faster and cheaper.
Since October 2020, ONTO stock has been on a moonshot, up 660%.
In the latest quarter, which ended March 31, its revenue was $228.8 million, which was 14.9% higher year over year. Its adjusted net income was $58.5 million, 30.0% higher than Q1 2024.
Only six analysts cover its stock, but five rate it a buy. Their target price is $250, 14% higher than where it’s currently trading.
From where I sit, and with no controlling shareholder in sight, it’s an acquisition waiting to happen. It’s not cheap, but if you’re patient, it should get bought out.
Comfort Systems USA (FIX)
Comfort Systems USA (NYSE:FIX) is the fourth-largest holding in DFAS by weight at 0.32%. The company’s name suggests it’s a mattress manufacturer. However, Comfort Systems actually has nothing to do with mattresses and everything to do with the new construction, renovation and remodel construction markets.
“We provide mechanical and electrical contracting services. Our mechanical segment principally includes heating, ventilation and air conditioning (“HVAC”), plumbing, piping and controls, as well as off-site construction, monitoring and fire protection,” states its 2023 10-K.
“Our electrical segment includes installation and servicing of electrical systems. We build, install, maintain, repair and replace mechanical, electrical and plumbing (“MEP”) systems throughout our 44 operating units with 172 locations in 131 cities throughout the United States.”
Mechanical services account for nearly 76% of its revenue, and electrical services account for the rest. New buildings represent 55% of that revenue, and renovations of existing buildings account for 45%.
It sounds like the perfect business to be in over the past few years. Its stock is up 502% over the past 60 months. How’s that for juice?
At the end of Q1 2024, it had a construction backlog of $5.9 billion, almost 8x what it was in 2016, and more than a year’s work in the future.
It’s a good spot to be in.
On the date of publication, Will Ashworth did not have (either directly or indirectly) any positions in the securities mentioned in this article. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com Publishing Guidelines.
On the date of publication, the responsible editor did not have (either directly or indirectly) any positions in the securities mentioned in this article.