A recent Bank of America Corp. (BAC) survey revealed that 92% of fund managers expect stagflation (slow economic growth and high inflation) over the next 12 months. Of course, the TradeSmith team isn’t here to just repeat the news and dump data in your lap. We’re here to show you what to do with that information.
And TradeSmith Senior Analyst Mike Burnick did just that in a Nov. 11 issue of TradeSmith Daily. Mike shared that the current stock market is reminding him of the stock market of the 1970s, a period marked by war, excessive money printing, and growth stocks getting crushed. Sound familiar?
The good news is that we can use history as our guide to not only survive in an era of stagflation — but thrive. For example, by looking back at the 1973 to 1975 recession, we can see that it was actually small-cap stocks (companies with market caps between $300 million and $2 billion) that led the way to economic recovery one year later. While large-cap stocks offered a 28% return, small-cap stocks offered more than double that at 58%.
Because of their size, small caps can more easily increase their revenue in a slowing economy. For instance, it’s easier for a company to make the jump from $100 million to $200 million in annual revenue than it is to go from $100 billion to $200 billion. Also, with the current strength of the dollar, small caps tend to be insulated from the negative impacts that come with currency fluctuations because their sales and earnings tend to be more domestic than international.
You’ll find no shortage of small caps to invest in, as there were nearly 2,000 as of December 2021. But you can’t just throw a dart and hope it lands on a winner. Instead, we’re going to share a “shortcut” for identifying the best stocks to own that will save you time and help keep you away from the stocks to avoid.
And it all uses TradeSmith’s proprietary technology. The secret is to look inside the holdings of small-cap ETFs (exchange-traded funds) and use our Health Indicator to see in an instant if any of the stocks are worth buying. Think of TradeSmith’s Health Indicator like a stoplight: If we see something in the Green Zone, we know it’s a “go.” It’s as simple as that.
Today, we’ll be looking for opportunities within two industry-specific ETFs and a broad one.
Stagflation Opportunity Shortcut No. 1: The Invesco S&P SmallCap Information Technology ETF
As beaten down as large-cap tech stocks have been, there are still hidden tech gems out there to discover within small caps. So, let’s start by taking a dive into the Invesco S&P SmallCap Information Technology ETF (PSCT), which invests 90% of its total assets in companies that comprise the S&P SmallCap 600 Capped Information Technology Index. That covers computer hardware and software, internet, electronic, semiconductor, and communication technology service providers.
And within the PSCT holdings is a company called PC Connection Inc. (CNXN). PC Connection provides computer systems, software, data center solutions, and more to small and medium-sized businesses, as well as larger corporations.
PC Connection Inc. (CNXN) at a Glance
- Opening Share Price as of Dec 1: $55.95
- Market Cap: $1.45 billion
- YTD Performance as of Dec. 1: +27.38%
- TradeSmith Health Indicator: Green Zone
- Volatility Quotient (VQ): 27.14%
- Risk: Medium
PC Connection is like a one-stop shop for anything you’d need when working with computers, with everything from computer parts to monitors to software and more.
On top of that, it also provides cloud services, cybersecurity, and other offerings to a whole host of sectors. That’s important because it means PC Connection doesn’t have all of its eggs in one basket. If it served just one particular industry and that industry suffered an economic downturn, so would PC Connection. But PC Connection advertises its products and services to state governments, the federal government, the health care industry, the retail industry, and more with a variety of products and services to fit every need.
In its latest Q3 earnings report, PC Connection noted year-over-year (YoY) increases in software sales (41%), health care revenue (14%), accessory sales (12%), and desktop sales (5%). The company did report a 9% decrease in notebook/mobility sales, but again, with all of the services PC Connection provides and the different industries it serves, it can balance any weakening demand from a certain segment with sales growth from more in-demand products and services.
Plus, PC Connection reported impressive increases in net sales and net income in the last quarter:
So, even with all the issues larger tech stocks are facing, this smaller company has reported positive net income for every quarter of 2022 so far.
For the next small-cap ETF, we’ll move into the biotechnology world.
Stagflation Opportunity Shortcut No. 2: The ALPS Medical Breakthroughs ETF
Biotech stocks are risky because many only have products in the pipeline that have yet to generate revenue. But that risk comes with a big reward if the company releases a blockbuster drug, which can propel the stock price upward like a speeding bullet as those recently released drugs rack up more sales each year. While you would never want to fill your portfolio exclusively with biotech stocks, it is worth having some on your radar for the more speculative section of your investments.
As an example, Catalyst Pharmaceuticals Inc. (CPRX) has skyrocketed 151% this year after receiving FDA approval for its drug Firdapse to treat Lambert-Eaton myasthenic syndrome (LEMS). LEMS is a rare condition that prevents muscles from tightening properly, leading to muscle weakness and other symptoms. Firdapse is the only approved treatment available to adults in the United States. Thanks to that market exclusivity, Catalyst Pharmaceuticals generated sales of $102 million in 2019, $119 million in 2020, and $141 million in 2021. The company expects total 2022 revenue to be between $205 million and $210 million, up from its previous forecast of $195 million to $205 million.
That’s why we’re taking a look at the holdings of ALPS Medical Breakthroughs ETF (SBIO) for small and mid-cap stocks that have one or more drugs in either Phase II or Phase III of clinical trials. And that’s where you’ll find Chinook Therapeutics Inc. (KDNY).
Chinook Therapeutics Inc. (KDNY) at a Glance
- Opening Share Price as of Dec. 1: $22.63
- Market Cap: $1.43 billion
- YTD Performance as of Dec. 1: +34.30%
- Health Indicator: Green Zone
- Volatility Quotient (VQ): 57.69%
- Risk: Sky High
More than one in seven U.S. adults have chronic kidney disease. And of those folks, as many as nine in 10 don’t even realize they have it. Research around rare kidney diseases is notoriously difficult due to a lack of sample size and the duration of time needed for follow-ups. But Chinook Therapeutics is looking to fill that gap, with the mission to discover, develop, and commercialize medicines for severe, rare, and chronic kidney diseases.
Source: Chinook November 2022 Presentation
One of the things that makes biotech investing so risky is the time, money, and uncertainty that comes with launching a new drug. It can take between 10 and 15 years and cost around $1 billion. And even after all that, there’s only a 10% chance that the drug will pass clinical trials. This is where it’s important to know your own risk tolerance. Because even with a Green Zone designation, our VQ puts Chinook at a sky-high risk of 57.69%. The good news is that Chinook’s not just talking about drugs it could develop — it actually has a number of treatments working through the pipeline at different phases.
Source: Chinook November 2022 Presentation
Stagflation Opportunity Shortcut No. 3: The S&P SmallCap 600 Index (SML)
Finally, another source for small-cap stock investing is within the S&P SmallCap 600 Index (SML). Nearly 60% of SML’s holdings are currently in the Red Zone, but there are still plenty of opportunities to uncover in the 37%-plus holdings that are in the Green Zone.
We previously shared three of those stocks in a Nov. 16 issue of TradeSmith Daily:
You can access that free issue here.
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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.