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Small-Cap Stocks and the Potential Melt-Up
This year’s bear markets have resulted in a fall in portfolio performance and investor confidence, but we see a turnaround in investor sentiment on the heels of the fear of missing out, aka FOMO. The fear and greed index has moved from extreme fear to the cusp of greed in a matter of weeks.
Fear & Greed Index (CNN Fear & Greed Index)
Investor portfolios have seen tremendous gains over the past few years, with the S&P 500 gaining nearly 50% over five years and Nasdaq up more than 60% for the same period, despite lockdowns and more than two years of a pandemic. With peak inflation and recession talks mounting, investors that have been keen on buying dips and flocking to make stock purchases based on greed rather than solid fundamentals may be creating what’s known as melt-up.
The sudden purchasing of stocks without clear economic reasons or indicators can lead to a rally. When led by greed versus fundamental market improvements, the markets may experience a “melt-up.” It’s the hype and desire to make money fast versus investing when the economy’s overall health is rising. Melt ups tempt investors to jump head-first into the rising performance that may result in short-term gains but can lead to a meltdown. A quick reminder is the many investors who became susceptible to the meme stock craze during the Reddit Revolution. Some investors were lucky enough to ride high during the melt up; others experienced the nosedive of the meltdown.
Charles H. Dow once said, “When the market is down and dull, it is hard to make people believe that this is the prelude to a period of activity and advance.”
Charles H. Dow Quote (Twitter, Michael Gayed, CFA)
The pullback in the markets has created potential buying opportunities for investors who were once fearful and are now in fear of missing out. As Goldman Sachs analysts said earlier this year,
“We believe small-cap stocks can continue to outperform in 2022. The expectation for earnings growth of Russell 2000 companies in 2022 is 30%, well above the 9% forecast for the S&P 500.”
Historically, small-cap stocks have outperformed large caps over long periods, but the recent market declines have resulted in small-cap stocks experiencing a period of underperformance. Where historically they have stood out, now could be the opportunity to plan for a rebound in small- and micro-cap stocks. There are many sectors and industries to choose from. Healthcare – pharmaceuticals in general – are defensive, have stood the test of time during up and down markets and throughout the pandemic, and should continue to be in demand. So I’m focusing this article on three Strong Buy pharma companies with solid fundamentals because, as of 2021, the U.S. is leading the global pharmaceutical market valued at approximately $1.42 trillion U.S. dollars, the biggest pharmaceutical market, generating more than $550B in revenue, according to Statista. Despite names like Pfizer (PFE), Merck & Co (MRK), and Johnson & Johnson (JNJ) that have paved the way for the industry, there are many smaller, up-and-coming speculative pharma companies for a bargain, capitalizing on the strong dollar in the U.S. amid the market downturn.
Worldwide Pharmaceutical Revenue from 2001-2021 (in billion USD)
Worldwide Pharmaceutical Revenue from 2001-2021 (in billion USD) (Statista)
Where large-cap companies tend to weather the turbulent market, they are finding it more difficult to profit in markets outside of the U.S., given the strong dollar. Consider the smaller pharma companies with strong fundamentals.
Micro-cap and small-cap stocks are smaller-sized companies that offer a great opportunity for long-term growth yet come with increased risks. Micro-cap companies, sometimes called penny stocks, tend to have a market capitalization of less than $300 million. Small-caps are between $300 million and $2 billion. Where volatility has been the name of the game this last year, Wall Street and Main Street are well aware that many stocks have declined. And where large-cap stocks – especially in tech – have been dragging the markets lower because of their size, the riskier U.S. equity asset classes like small-cap stocks are becoming more attractive options. SOFI Head of Investment Strategy Liz Young points out in the chart below that small-cap stocks have outperformed large-caps in six out of the last six recessions. Whether or not we’re in a recession is debatable, it’s good to consider ideas in hopes of capitalizing; the early bird gets the worm.
S&P 500 & Russell 2000 Performance 12-Month Post Recession (Twitter, Liz Young)
Where some are willing to go a bit further and consider more risk, there’s also opportunity in micro-cap. Considered riskier because of their smaller size, some of the pros of micro caps are that they can offer tax deductions from capital losses. As both types of stocks tend to go through high growth periods with higher leverage, they tend to sell off sharply when rising interest rates are threatened. Diminutive companies also tend to have less profitability, reinvesting anything earned back into the company. In the current contractionary environment, smaller companies tend to sell off more than large-cap stocks, which is why it’s vital to proceed with caution when it comes to these types of investments.
Although past performance is not a guarantee of future results, historically, small-caps have outperformed large-cap stocks. And where high levels of inflation and the strong U.S. dollar are most affecting large caps, smaller companies stand to benefit. The key is finding those with the attractive collective financial traits our Quant Ratings seek; solid valuation, strong growth, EPS revisions, profitability, and momentum. These qualities are currently found in the three stocks below.
Quant Factor Grades (Seeking Alpha Premium)
Where speculative pharmaceutical companies can be risky, focusing on strong buy ratings and metrics is an opportunity for long-term consideration in a portfolio. Let us dive into my picks.
Market Capitalization: $898.92M
Quant Rating: Strong Buy
Quant Sector Ranking (as of 10/25): 10 out of 1192
Quant Industry Ranking (as of 10/25): 6 out of 228
Verona Pharma is a clinical-stage biopharmaceutical company focused on treating respiratory diseases. Headquartered in London, England, VRNA focuses on improving the health and quality of life for people with chronic conditions like chronic obstructive pulmonary disease (COPD), cystic fibrosis (CF), and asthma. Where clinical trials take years to develop, this small-cap stock is still in its infancy and growth stages, improving metrics, thus in its developmental stages as well. In the words of Verona Pharma, they’re a “Breath of Innovation®,” and Seeking Alpha’s quant grades have rated this small-cap stock a Strong Buy.
Incorporated in 2005, Verona Pharma is a relatively new company that IPOd on April 26, 2017, and has been focused on growth. Although some of the underlying valuation metrics are less than ideal, those proprietary to the quantitative metrics and weighted more heavily offer an optimistic outlook to VRNA, which boosts its valuation grade to a C+. As we look at the success of Verona and its longer-term uptrend, not only is VRNA 125.64% in one year, it’s outperforming the S&P 500 (-14.92%) and NASDAQ (-26.46%) significantly, and quarterly, it’s also outperformed its sector peers.
VRNA Momentum Grade (Seeking Alpha Premium)
In reviewing its momentum grades above, it’s obvious why analysts are calling the stock overbought. Investors are actively purchasing shares which drives the price higher. One of the latest highlights for the company is that Verona Pharma shares surged nearly 100% after sharing the news of its positive results from Phase III ENHANCE – 2 trial of ensifentrine, which treats COPD. The market opportunity for COPD is significant, as maintenance treatments are generating $10B in sales in the U.S. alone. Following the results, Verona Pharma’s President & CEO, David Zaccardelli, said,
“We are very pleased by the successful outcome of our ENHANCE-2 study and remain committed to bringing ensifentrine to COPD patients as quickly as possible. These data, along with results from our ongoing Phase III trial, ENHANCE-1, which is on track to be reported around the end of 2022, if similarly positive, are expected to support the submission of a New Drug Application to the US Food and Drug Administration in the first half of 2023.”
With the developments of ENHANCE-2, Verona and its partner Nuance received the okay to begin the development of drug trials in China. Although we’ve seen the geopolitical risks involved in operating overseas, particularly in Mainland China, this is an important milestone for the company, its growth, and the global need for treatments.
Verona Pharma possesses solid overall growth and profitability metrics. Like any smaller company in its growth stages, everything is reinvested back into the company to operate and support studies while working to gain regulatory approval for products and treatments.
VRNA is focused on targeted commercialized strategies in supporting the launch of its products. Where Verona Pharma has a C- Growth Grade and solid B Profitability grade, following its second-quarter earnings, Q2 GAAP EPS of $-0.04 beat by $0.23, and $111m cash and cash equivalents from the U.K. tax credit program to become available will help fund its planned OPEX and CAPEX through 2023.
VRNA Targeted Strategies (Verona 22Q2 Investor Presentation)
With the company’s business objectives involving the advance of clinical and regulatory activities that can take many years for approval, according to Verona Pharma’s condensed Q2 quarterly report:
“In March 2021, the Company entered into an open market sale agreement with respect to an at-the-market offering program (the “ATM Program”) under which the Company may issue and sell its ordinary shares in the form of ADSs, with an aggregate offering price of up to $100.0 million.
During the six months ended June 30, 2022, the Company sold 80,696 ordinary shares (equivalent to 10,087 ADSs) under the ATM Program at an average price of approximately $0.86 per share (equivalent to $6.86 per ADS), raising aggregate net proceeds of approximately $0.1 million after deducting issuance costs. As of June 30, 2022, there remained ordinary shares, in the form of ADSs, with a value up to $99.2 million available for sale under the ATM Program.”
This strategic initiative allows VRNA to raise capital over time by selling its shares through a follow-on public offering (FPO), which enables exchange-listed companies to sell newly issued shares via a designated broker-dealer, to control the timing and amounts of capital raised and take advantage of share prices. To showcase the benefits of its structure, Seeking Alpha Marketplace author Terry Chrisomalis writes:
“(Verona Pharma) announced its earnings update, it also disclosed an upsized public offering. It sold a total of 12,400,000 American Depositary Shares (“ADSs”), each consisting of 8 ordinary shares of Verona Pharma.
In total, it raised an aggregate amount of gross proceeds of $130.2 million before deducting expenses. With this cash raise done just recently, it has now extended its cash runway to mid-2024.”
VRNA EPS Revisions (Seeking Alpha Premium)
With more capital raised to advance its objective, bullish momentum, and five analysts revising estimates up in the last 90 days, VRNA is a Strong Buy rated stock to watch going forward, along with my next pick.
Market Capitalization: $113.70M
Quant Rating: Strong Buy
Quant Sector Ranking (as of 10/25): 7 out of 1192
Quant Industry Ranking (as of 10/25): 3 out of 228
Assertio Holdings, Inc. is a quant-rated Strong Buy specialty pharmaceutical company on the rise, despite its shares plunging amid news of a $60M of convertible senior notes offering to qualified institutional buyers. The net proceeds are expected to be used for repurchase or to redeem 13% of senior secured notes due in 2024, but the markets did not seem too happy.
ASRT Factor Grades (Seeking Alpha Premium)
Despite the slide in price, Assertio’s Factor Grades, which rate investment characteristics on a sector-relative basis, are excellent. Above, the Profitability and Revisions Grades indicate that ASRT has excellent potential and is fundamentally sound compared to the sector. With a current A+ Profitability grade and an A- Earnings Revision, ASRT is one of the most profitable companies in its sector, it’s no wonder they have consecutively beaten earnings expectations, raising guidance yet again after Q2 reports.
I wrote about ASRT in April as one of my Cheap Stocks Under $10 to Buy. Despite its fall in share price on the heels of the convertible note offer, the stock still possesses tremendous fundamentals and continues to deliver results.
With an EPS of $0.16 that beat by $0.08 and revenue of $35.13M that beat by nearly 40% year-over-year, second-quarter results exceeded expectations. In addition to an increase in the growth of suppository volumes (+7% YoY), its SPRIX product experienced a 20% increase in the same period and increases to net product sales. With its new digital strategy that has helped restructure and focus the business, gross margins, operating expenses, cash flows, and overall strategies have improved.
“We expect net product sales to be $129 million to $137 million and adjusted EBITDA to be $73 million to $79 million. The drivers behind the outsized EBITDA improvements relative to revenues are both the actual results shown in the quarter as well as an outlook for better gross profit margins than we had initially assumed given all the improvements we’ve seen year-to-date,” said CEO Daniel Peisert.
ASRT Profitability Grade (Seeking Alpha Premium)
In addition to higher net sales, a solid balance sheet, and cash, ASRT is focused on debt reduction in capitalizing on new opportunities. In addition to its bullish momentum that many analysts call the stock overbought, ASRT comes severely discounted.
ASRT’s valuation grade is an A+ with a one-year price increase of 140%. In addition, ASRT is trading more than 75% below its sector peers with a 4.32x forward P/E ratio and a forward PEG of 0.43x, as evidenced by the below figures.
ASRT Valuation (Seeking Alpha Premium)
If you haven’t gotten in on the action with this stock when I first wrote about it, especially at its current $2.45/share price, ASRT is a strong buy to consider.
Market Capitalization: $165.21M
Quant Rating: Strong Buy
Quant Sector Ranking (as of 10/25): 12 out of 1192
Quant Industry Ranking (as of 10/25): 7 out of 228
ProPhase Labs, Inc. is another small-cap stock with tremendous upside potential. Like each of my picks throughout this article, PRPH is in a growth phase yet is already profitable. Engaged in the research, development, and distribution of dietary supplements in the U.S. and energy and stamina boosters, PRPH offers strong fundamentals and had incremental revenue growth.
With three consecutive earnings beats, PRPH crushed its latest earnings results. EPS of $0.40 beat by $0.24, and revenue of $29.09M beat by a whopping 218%, generating $29.1M! These figures have resulted in two analyst FY1 Up revisions in the last 90 days and goals for continued growth opportunities.
PRPH Stock Revisions & EPS (Seeking Alpha Premium)
As a result of the tremendous success, PRPH has had the ability to pay dividends. While not regularly paying dividends, during the Q2 Earnings Call, as ProPhase CEO Ted Karkus expressed:
“Our stock price up almost 20 times while paying out a significant amount of dividends. So as far as I’m concerned, we’re doing all the right things, and the stock price will take care of itself if we continue to execute. And the businesses that we are working on now have enormous upside potential. I can’t tell you on a month-to-month basis,
What’s going to happen, but I can tell you that, you know, over the next year and a half, between the potential nebula and the potential of ProPhase Biopharma while diversifying our diagnostics business, there’s still significant upside from where we are now.”
With a strong revenue outlook and improved cash position that includes $53.6M in working capital as of June 30, 2022, ProPhase continues to increase its numbers yearly, while still coming at an extreme discount.
Showcasing an A+ overall valuation grade, despite its uptrend, PRPH is undervalued. With a forward P/E ratio of 7.31x compared to the sector media 23.23x and forward EV/Sales of 1.25x, both showcase a difference of more than 66% compared to their sector peers.
PRPH is trending higher on a longer-term uptrend as investors are purchasing more shares. Up 57% YTD and +95% over the last year, despite its rise in share price, the stock continues to trade at a discount while outperforming its sector peers quarterly.
PRPH Valuation Grade (Seeking Alpha Premium)
Undervalued with tremendous momentum, this discounted stock is ripe for the picking, with the earnings to match. Where each of these stocks has great potential for the melt-up and long term, there is risk involved in investing and holding smaller companies that may also be susceptible to a meltdown. Examine these stock picks and their strong quant ratings in diversifying your portfolio. Wall Street and Main Street are warming up small-cap stocks for a potential melt-up.
Small-cap stocks, especially in the pharmaceutical healthcare space, can be significantly more volatile than the markets we’ve seen lately. Treatments and trials are speculative until proof of concept is established. From a discount perspective, small-cap stocks come not only at a great price but typically with more upside potential, as we’ve seen over the last few years relative to large caps.
Despite the volatility of small-caps, which can experience deep troughs and high growth periods, VRNA, ASRT, and PRPH were selected using Seeking Alpha’s Quant System by identifying stocks with market caps under $2B and with strong collective fundamentals. The stocks featured here may help to diversify your portfolio while also positioning yourself to capitalize on a potential melt-up. There are dozens of Top Stocks Under $10 rated Strong Buys as potential investments. Consider using investment research tools and screens to help ensure you’re furnished with the best resources to make informed investment decisions.
This article was written by
Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.