After a tumultuous 2022, small-cap value stocks have rebounded sharply so far this year, outperforming the S&P 500 by more than 2%. It may be alarming, but statistical analysis shows that small caps tend to outperform the broader market during the economic contraction and early recovery stages, so there’s no reason to panic.
Small cap value in current market conditions
Small-cap stocks (“size” in the chart below) have outperformed the broader equity market during recessions and the early stages of economic recovery, according to US-based regression analysis.
Source: Research Affiliates
Economic forecasts for 2023 remain balanced as some economists forecast a recession, but some believe the US believes it will avoid a recession. Small-cap value stocks could outperform the broader market in either of two scenarios.
The results of the aforementioned regression analysis are no fluke. In fact, they align with the philosophies of two of his more prominent experts: Eugene Fama and Omaha oracle Warren Buffett (Trades, Portfolio). Buffett’s “cigar butt” approach (a strategy established by Benjamin Graham) assumes a pragmatic perspective, whereas Fama statistically found long-term outperformance of small-cap value assets. Though methodologically different, Fama and his Buffett approach are closely aligned, providing a blueprint for investors to outperform the market by investing in stocks that are underperforming. .
To simplify matters, small cap value stocks basically rely on simple mean reversion. However, there are many failed companies in this segment. Therefore, comprehensive research is required before making investment decisions.
Here are two lucrative small-cap value stocks worth considering.
Brandywine Realty Trust
Real estate investment trusts allow investors to invest in real estate without liquidity risk. Additionally, investors can realize similar percentage-based returns while investing less capital.
Brandywine Realty Trust (NYSE:BDN) is an often overlooked REIT that specializes in fully integrated mixed real estate investments across the United States.
The fund beat 8 cents per share in earnings, well above its most recent quarterly forecast. The driving force behind Brandywine’s impressive quarter was his quarterly uptime up to 90.8%. This corresponded to an increase in base rents, which resulted in a surge in total funding from operations.
According to GuruFocus, Brandywine is relatively undervalued, with a price-to-performance ratio of 5.8 in the top 20 percentile of the REIT space. In addition, the 12.2% dividend yield is best in class, providing investors with a profitable total return opportunity.
M/I Homes Inc. (NYSE:MHO) shares are in deep value territory at 0.75 on the stock index, suggesting the market is underestimating the company’s split value.
Much of the gap in the stock price is due to market skepticism about M/I’s business model, which is centered on US residential construction. The broad story is that home builders could bear the brunt of a recession amid rising loan rates and resilient inflation. However, M/I Homes boasts a very strong operating margin of 15.46% and his three-year EBITDA growth of 43.5%, demonstrating long-term growth attributes.
Based on M/I Homes’ income statement, the company operates a lean business model that thrives on customer loyalty, providing the tools necessary to phase out systemic risk in the industry. I’m here.
Indeed, the company’s latest earnings release outlines the risk factors as backlog fell 16% and new contracts fell 31%. Since then, however, the stock has risen nearly 20%, and the market is ignoring past results. Market ignorance is likely due to the consensus that MI/Homes could benefit from his revitalized economy in late 2023, as interest rate pivots are underway.
M/I Homes has not paid a dividend since 2008, but its share price is significantly undervalued, providing a healthy opportunity for price speculation.
Risks worth considering
Small-cap value investing is often applied to crashing stocks that are likely to recover. Contradictory views are therefore usually assumed, and risks can arise if the short-term market outlook is inaccurate.
Both Brandywine Realty Trust and M/I Homes are cyclical securities facing an uncertain economy. As such, risk-adjusted returns may not be suitable for all investors. Nevertheless, speculative investors may benefit from opportunities such as the ultimate risk-reward play.
Statistical analysis and Buffett’s cigar bat strategy are more effective than ever in today’s financial market environment. Combined year-to-date performance and regression analysis of small-cap value assets show that this segment has the potential to outperform the broader market as macroeconomic variables shift.
Securities such as Brandywine Realty Trust and M/I Homes could benefit from the 2023 small-cap outlier, offering investors an opportunity to secure favorable total returns.
This article was originally published on GuruFocus.