If Rates Rise, Small Caps Like These 6 Stocks Could Still Lead

Disclosure: I'm long Overseas Shipholding, Dynegy, American Woodmark and John B. Sanfilippo & Son.

Given how long we've been hovering in a low interest rate environment, it's hard to imagine things changing. The zero interest rate policy (ZIRP) implemented in 2008 by then Fed Chairman Ben Bernanke (to bolster spending, borrowing and investment) lasted seven years until December 2015 when the Federal Open Market Committee (FOMC) increased its target rate to between 0.25% and 0.50%. And while the general expectation is that the Fed will raise rates in the coming months, the size and spacing of such increases are the subject of much speculation.

This period of anticipation raises questions concerning how a rate hike will affect the small cap class of assets, particularly given its historically strong long-term performance versus its more recent weak performance. In a MarketWatch article from back in 2014, Paul Merriman provided data showing that, on the whole, even though there have been periods where they lagged behind large caps, small caps have been the better performers:

However, when you look at what has transpired in recent years in the small cap space, you will see the performance has trailed larger names. Since the end of 2013, the Russell 2000 (a broad small cap company index), is up 10.5% on a total return basis. Compare this to the S&P 500’s return of 24.2% and the Russell 1000 (a large cap index) of 23.2% and it’s clear that over that three-year period the market has favored larger names over smaller ones. In the past six months, however, there has been an uptick in small cap performance that might beg the question as to the potential impact of a rate hike.

A U.S. News and World Report article from June states, "Small-capitalization stocks have been on a tear since February. After a long period of lagging performance, small-cap stocks stole center stage in the recent recovery in U.S. equities." The article quotes Terry Sandven, chief equity strategist at U.S. Bank Wealth Management in Minneapolis, who believes the "resurgence of small-cap performance from the February low is typically a positive omen for economic growth. Small caps tend to outperform when the economy is expanding and the risk of a looming recession is low."

So What If Rates Go Up?

Conventional wisdom says that rising interest rates can have a negative impact on equity investors in general and small-cap stocks (market capitalization of between $250 million and $2 billion) in particular due to the following:

*Small caps generally need more external capital to grow than large caps and, since higher rates drive up the cost of capital, their growth becomes more expensive.

*The popular view is that the market values equities based on discounted future cash flows. Since higher rates generally mean higher discount rates, small-cap shares (which tend to be more dependent on future revenue streams) are more sensitive to rate shifts.

The reality, however, is that small cap stocks have historically tended to perform better than large cap stocks during rising interest rate environments , as outlined in the following charts below. For starters, smaller companies tend to exhibit strong relative returns during periods of economic growth, and typically the Fed's raising of interest rates are associated with periods of good economic growth.

The second reason for small cap outperformance may be a function of underperformance leading up to the period when rates are set to increase. As the market anticipates the start of a rate increase cycle, investors shun smaller caps (for the reasons mentioned above) but once rates actually start to move higher, as a result of growth, investors wake up to the relative value in the small cap universe vs. other areas of the market.

Using our Guru Stock Screener, I've identified six small-cap stocks that earn high marks.

The first three score well under our screen inspired by quant investor Joseph Piotroski, who focused on unpopular stocks whose book values (total assets minus total liabilities) were high compared to the value investors ascribed to them (market cap). Our model incorporates additional criteria he used to differentiate between those stocks that are undervalued and those suffering from financial weakness. Note this model brings in some of the most beaten down stocks in the market.

Noble (NE) is an offshore drilling contractor for the oil and gas industry (market cap of $1.45 billion). It earns a perfect score under our Piotroski-inspired screen, which first requires a company to be in the top 20% of the market based on the book-market ratio (the inverse of the price-book ratio). The other criteria in this model ascertain whether the company is fundamentally sound or trading at a discount due to financial weakness. Noble shows well with return on assets 3.88%, positive operating cash flow ($1.76 billion) and modest long term debt-to-assets (0.32).

Overseas Shipholding Group (OSG) operates a fleet of oceangoing vessels engaged in the transportation of crude oil and petroleum products (market cap of $774 million). Our Piotroski-based screen likes Overseas Shipholding's book-market ratio of 2.0 coupled with return-on-assets of 5.51% (in the most recent year), which represents a substantial improvement over the prior year. In the 2015 annual earnings release statement, CEO Capt. Ian Blackley attributes improved earnings performance, in part, to increased gasoline consumption stemming from lower oil prices. Positive operating cash flow of $299.07 million exceeds net income ($178.09 million), another plus under this model.

Dynegy (DYN), through its subsidiaries, sells electric energy, capacity and ancillary services from a fleet of more than 30 power plants across eight states (market cap of $1.6 billion). The company's book-market ratio of 1.25 coupled with a considerable improvement in return-on-assets (0.23% up from minus 2.93% in the prior year) passes our Piotroski-based screen. Operating cash flow of $94 million well exceeds net income of $25.72 million, a requirement under this model. Long term debt-assets has held steady at a moderate 0.62.

The following three stocks get high marks from our James O'Shaughnessy-based Cornerstone Growth screening model that focuses on market capitalization, earnings-per-share, price-sales ratio and relative strength as key criteria:

American Woodmark (AMWD) manufactures and distributes kitchen cabinets and vanities for remodeling and new home construction. The company earns a perfect score under the O'Shaughnessy-based model given its size (market cap of $1.4 billion versus minimum requirement of $150 million) and persistent growth in earnings-per-share over the last 5 years (to $3.57 for the most current year). Relative strength of 77 and price-sales ratio of 1.44 both satisfy this model's requirements.

IES Holdings (IESC) provides technology infrastructure services to corporations and independent businesses as well as electrical installation services, electrical design, construction and maintenance services for residential and commercial customers (market cap of $371 million). The company passes this screen due to its modest price-sales ratio (0.57 versus 1.5 maximum), persistent EPS growth and relative strength of 95 (in the top 50 stocks that pass this screen).

John B. Sanfilippo & Son (JBSS) is a processor and distributor of peanuts and tree nuts and a distributor of a diverse product line of food and snack products (market cap of $594 million). The persistent EPS growth over the past five years satisfies the O'Shaughnessy-inspired model as well as its moderate price-sales ratio (0.62) and relative strength of 67.