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3 Small Cap Stocks to Buy in June for Big Returns

One of the best segments of the market, a group of stocks that has beaten the market by 88% over two decades, is almost completely ignored by most investors. In this video, I’ll show you why small cap stocks need to be a part of your portfolio and how to find the best. I’ll then reveal three small cap stock picks I’m buying for June in my favorite stock sectors. We’re talking small cap stocks to buy, today on Let’s Talk Money!

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Nation, we uncovered some big gaps in our 2021 Bow Tie Nation portfolio when we did that review two weeks ago. Almost a third of the portfolio, 28% is in healthcare stocks and we’re overweight in Financials, Energy and Communication Services.

And while I like all four of these sectors, we’ve got almost nothing in two of my favorite sectors for the year; stocks of Industrial and Basic Materials companies.

After positioning early in stocks of financials and energy companies, the portfolio is up 37% so far and beating the market by 26% this year. But I think stocks in the industrials and materials sectors could be the next to really take off. Both benefit from moderate inflation and the kind of economic growth we’re starting to see.

So I wanted to use our June video to fill in those gaps, add three stocks to the portfolio but not just for the sake of getting stocks in these sectors. I want to find three stocks with not only that sector upside but also the potential for even higher returns.

finding small cap stocks

In this video, I’ll show you why small cap stocks need to be a part of your portfolio and why they beat the market return. I’ll give you a step-by-step to finding the best small cap stocks to buy and then reveal the three small stocks I’m buying right now!

We won’t be doing a review of the portfolio this month because I want to get to those small cap stock picks. I’ll leave a link to Stockcard below. Click through and then go to Portfolios in the top menu, you’ll find the Bow Tie Nation portfolio in this Stock Picks section. It’s free to follow and you’ll get email notifications whenever I buy or sell from the portfolio.

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3 Small Cap Stocks You Should be Buying this June

First up in our small cap stocks list is Nexa Resources, ticker NEXA, a $1.3 billion zinc miner with assets across Latin America.

Nexa is the largest of the small caps we’ll look at but still very much a small miner like Freeport-McMoRan. Still, the company is the fifth largest zinc producer with mines in Peru and Brazil, producing over 500,000 tons in the first quarter.

While zinc might not get the attention of copper or gold in the markets, it’s a key component in construction and automotive, two industries with great near-term growth. About 170,000 tons of zinc is needed each year for renewable energy projects as well, so lots of growth in demand.

The company has a strong pipeline of developmental mines as well, helping it to keep up production growth as prices head higher. About two-thirds of production is from zinc with another 16% from copper and 13% in silver mining and like almost all commodities, these have seen prices take off over the last year. Zinc is up 108% since the beginning of 2020, the price of copper is up 161%.

And the company has a strategic advantage in its smelting operations with 52% of source input from its own mines, so it’s got a strong vertically-integrated position.

The company reported 36% year-over-year revenue growth last quarter to $603 million though the COVID closures hurt it last year. It’s getting back on track though and still booked $2.1 billion in sales over the last year.

The balance sheet is a little shakier than what I usually like to see in these small cap stocks. Nexa has a billion dollars in balance sheet cash against $1.9 billion in debt but there’s no major debt maturities until 2027 and it’s a cash flow business. There are plenty of assets here and financial flexibility, so not really worried about the debt.

And besides its position in the materials sector, and again I love this sector for this year and next, the valuation on this stock is insanely low. Shares trade for just 0.63-times sales versus an average for the mining industry of 3.1-times sales.

That lower valuation is mostly due to Peru and Brazil being so far behind other countries in dealing with the pandemic but they are starting to turn it around and when that happens, a lot of value gets unlocked from these shares.

what are small cap stocks

Now is on the high side of what we consider a small cap stock but there’s some real opportunity in these smaller companies so I want to explain what these are and why they tend to beat the market. When we talk about small cap stocks, we’re talking about the company size, its market capitalization. Market capitalization is the total market value of the shares, so it’s the share price times all the shares available and investors usually think of this in four sizes; Mega-cap companies are those worth more than $300 billion so you’ve got the huge companies like trillion-dollar Apple and Facebook. Large cap companies are pretty big too though with a size from $20 billion to $300 billion. Then you’ve got mid-cap which is generally $2 billion to $20 billion and small cap stocks are $300 million to $2 billion.

What Makes Small Cap Stocks a Good Investment?

So small cap companies aren’t quite as risky as some of the penny stocks we cover on the channel but are still small enough for more flexibility versus the larger, established players. They’ve grown large enough to find a segment of the market they can focus on and serve it better.

And that’s what makes these such a great investment. Small cap companies can focus on a specific niche of a market, so a segment of the whole, and serve those customers better than a large company serving the entire market. Some of this is just the law of large numbers. A large $20 billion company with $5 billion in sales needs to target every part of the market but a smaller company that’s only building from a base of $500 million in sales, it can focus on that niche segment to take share away from the bigger rival. It might only be able to grab another $100 million in sales but that’s still 20% growth versus the big company that would have to increase sales by a billion to do the same growth.

And the proof is in the returns. The Russell 2000 index of small cap stocks has beaten the S&P 500 by 88% over the past two decades. There are periods of underperformance. Small cap stocks tend to do worse in a recession or a crash, so you see the gap narrow in the chart around 2008 and 2020, but over time small caps build on that outperformance for higher returns.

Next on our small caps list is PAE Incorporated, ticker PAE, a $773 million provider of operational and outsourcing services, primarily to the U.S. government.

The chart here is a little busy but it gives us a great overview of the company. The light blue ring shows you the five segments in which the company operates from intelligence and technology services to business processes, logistics and engineering. The next two rings are 2020 and 2021 revenue mix for each, so we see about 50% of revenues come from that infrastructure, engineering and mission readiness segments. Finally the outer ring shows the margin profitability on each, so a little lower margin on the two biggest segments but stronger profitability on others and that’s actually where the growth is as well.

The company recently confirmed its 2021 guidance for $3.1 billion in sales and $120 million in operating cash flow, which for a $773 million company to be producing over $3 billion in sales is very rare.

PAE has a project backlog of $7.9 billion and is renewing 93% of its contracts with the government when they’re completed so a strong outlook for future revenue. The company is also improving profitability, improving its earnings margin by 0.6% last year to 6.6% with a long-term target of 8%.

That $3 billion revenue target would be 14% growth from last year and means the shares are trading for just 0.25-times on a price-to-sales basis. That’s half the average price multiple on the closest comparables like Vectrus, ticker VEC, which trades for 0.4-times sales and AECOM, ticker ACM, which trades for 0.7-times sales. In fact, this stock could come up 40% and still be a better value than its two closest competitors.

We’ve still got the smallest of the three stocks to highlight but I want to give you three steps to finding the best small cap stocks, three factors to watch for picking these stocks.

First is you’re looking for companies that can grow their revenue year after year and not just total sales but also cash flows. You’ll find revenue reported on the income statement and can look at the statement of cash flows for the trend in operating cash flow.

This is really where it has to start, right? These smaller companies aren’t coming into virgin product markets. They’re competing against big, established players. If that small company can’t develop some kind of an advantage that comes through in higher sales then it’s sunk before it gets out the bay.

I also like to see improvements on profitability, specifically that each year the operating profit margin gets a little higher. Remember, that operating margin is just the operating income, so what’s left of sales after paying all the business expenses, that divided by sales.

So not only do you want to see a company growing sales but you want to see that it’s getting more efficient, more profitable at doing it. Put these two together and the company is going to be on a path for higher earnings and returns.

Finally here, for small companies, I want to look into its reports to find the addressable market and some kind of a competitive advantage.

This one is subjective and is going to take a little more research but I’m looking for management’s plan on competing against those bigger established players. I want to hear that the company is targeting a smaller segment of the market for that product and that it has a plan for how it’s going to beat the big dogs in that segment. What I don’t want to see is a small company trying to compete against Goliath and serve the entire market. Most small companies just don’t have the financial strength to do that, it’s just not going to happen.

The smallest of our small cap stocks I’m buying, US Xpress Enterprises, ticker USX. The company is the 5th largest asset-based truckload carrier in the U.S. with over 6,000 tractors and 13,000 trailers and a terminal network across the country.

Now the entire trucking industry should have a good year on the rebound in retail sales and consumer spending…if it can fix the driver shortage. And that’s actually why USX is one of the most interesting stocks I’ve seen in a long time.

The company’s Variant program is an app-based model using AI on a digital platform to revolutionize trucking. It’s like an UBER for truckers! The program expanded to 951 trucks last quarter and on pace to hit a target of 1,500 by the end of the year. The program has already driven 26% higher miles per week from drivers and a 61% improvement in driver turnover, which in that years-long driver shortage is a game-changer.

The acquisition of transportation data services last month builds on its cloud software tools to further increase productivity and I love that the company is on the forefront of implementing tech solutions in trucking.

Sales were only up 6% last quarter but operating income jumped and the company returned to net profitability against a tough 2020. Analysts expect USX to report $1.9 billion in sales this year and $0.99 in per share earnings.

That puts the shares at just 0.28-times sales and 10.7-times on a price-to-earnings basis. It’s a third the multiple on shares of Schneider National on a sales basis and half the PE ratio. Now it seems like the discount on valuation is on the uncertainty around the Variant rollout but if the company can execute on that program, it could revolutionize trucking and this could be a $20 or $30 stock by the end of the year.

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