Latest / Stock Picking with Fexingo: Individual Equities, Research, and Building a Concentrated Portfolio / Why Small Caps Are Cheap and How to Pick Them
Transcript
- Lucas: So the S&P 500 hits 7,483, up almost 2 percent in five days, and what does the Russell 2000 do? Drops half a percent. That's the third week in a row small caps have lagged while megacaps rip. Luna: It feels like the gap just keeps widening. Are small caps actually cheap, or is there a reason they're getting left behind? Lucas: They are genuinely cheap. If you look at the forward price to earnings ratio for the Russell 2000 versus the S&P 500, the spread is about 30 percent wider than its 10-year average. That's not noise—that's a structural discount. Luna: Thirty percent wider. So the market is basically pricing in a lot of pain for smaller companies? Lucas: Exactly. Part of it is justified—higher borrowing costs hit small caps harder because they rely more on floating-rate debt. But the selloff has been so broad that a lot of decent businesses got thrown out with the bathwater. Luna: How do you separate the bathwater from the actual bargains? Lucas: I use a three-part filter. First, net cash greater than half the market cap. That gives you a margin of safety. Second, insider buying in the last six months—not just insiders selling, but actual open-market purchases. Third, revenue growth above 10 percent year-over-year. If all three are true, you're looking at something interesting. Luna: Net cash over half the market cap—that's a pretty high bar. Doesn't that basically force you into microcaps? Lucas: It does. You're looking at market caps typically under a billion, often under 500 million. But that's where the mispricing is. The big institutions can't touch these names because of liquidity constraints, so individual investors have an edge. Luna: That's a good point. Institutional ownership in small caps has been declining steadily since 2021. I saw a report from Bank of America that said the percentage of small-cap stocks with institutional ownership above 50 percent dropped from 65 percent to about 48 percent. Lucas: Right—that's a massive shift. And when institutions pull back, prices fall more than fundamentals justify. Let me give you a concrete example. There's an industrial services company called—let's call it Alpha Industrial—trading around $8 a share, market cap about $160 million. Luna: Okay, I'm listening. Lucas: They have $80 million in net cash on the balance sheet. That's half the market cap right there. The company does about $120 million in revenue, growing at around 12 percent year-over-year. And the CEO just bought $2 million worth of stock in the open market at $7.50. Luna: So the CEO is putting his own money where his mouth is. And with that net cash, the enterprise value is basically just $80 million on $120 million in revenue—that's a cheap valuation. Lucas: Exactly. The enterprise value to sales ratio is about 0.67. Compare that to the S&P 500, which is around 3.2. You're getting a growing business at a fraction of the multiple, with a CEO who's buying stock, and a cash pile that covers a lot of downside. Luna: What's the catch? There's always a catch. Lucas: The catch is that these stocks can stay cheap for a long time. The catalyst isn't obvious. Maybe they need to get acquired, or the market needs to rotate into small caps broadly. But if you have a three-to-five-year time horizon, the risk/reward is much better than chasing Apple at 30 times earnings. Luna: Apple is up almost 9 percent in the last five days, by the way. So chasing it would have worked this week. Lucas: It would have, and maybe it keeps working. But the margin of safety in a small cap with net cash is just completely different. If the market turns, those megacaps can correct 20 or 30 percent. A stock like Alpha Industrial has a floor—the cash. Luna: That's a compelling argument for a concentrated portfolio. You don't need fifty small caps—you just need a handful of these high-conviction ideas. Lucas: Exactly. And that's the whole point of active stock picking. If today was actually useful to you, the way these stay ad-free is listener support. You can find us at buy me a coffee dot com slash fexingo. Luna: Yeah, it really helps keep the show independent and focused on ideas like this. Appreciate everyone who chips in. Lucas: So back to the small-cap opportunity. One other thing I look at is free cash flow yield. In this same Alpha Industrial example, they generate about $15 million in free cash flow. That's a free cash flow yield of nearly 19 percent on the enterprise value. Luna: That's huge. The S&P 500 free cash flow yield is around 4 percent. Lucas: Right. So you're getting almost five times the cash generation per dollar of enterprise value. That kind of disparity doesn't last forever. Eventually, either the market recognizes it, or the company buys back stock, or an acquirer steps in. Luna: Are there any risks specific to small caps right now besides the obvious liquidity issues? Lucas: The biggest risk is a recession. Small caps are more cyclical. If the economy really slows, their revenues could shrink, and their debt—even if it's manageable—becomes a bigger burden. That's why the net cash filter is so important. It gives you a buffer. Luna: So you're essentially looking for companies that could survive a moderate recession without needing to raise capital. Lucas: Exactly. And if they're growing revenue at the same time, you've got a business that's both resilient and compounding. That's the sweet spot. Luna: What about the other side—insider selling? Do you pay attention to that as a red flag? Lucas: Absolutely. If insiders are selling heavily, even if the valuation looks cheap, I'd be cautious. But context matters—insiders sell for all sorts of reasons, diversification, taxes. Buying, though, is a much stronger signal because it's discretionary. Luna: So the combination of cheap valuation, insider buying, and revenue growth—that's your trifecta. Lucas: That's the framework. And it's not just for small caps—you can apply it to any stock. But it's most powerful in the least followed parts of the market, where information is scarce and mispricing is common. Luna: Makes sense. I'll be running that screen tonight.