It's been shown small-cap stocks can outperform large-cap stocks over time, so it's not surprising that many investors want to include up-and-coming small caps in their investment portfolios. The challenge is figuring out which are the best small-cap stocks to buy, and knowing when to buy them can be even more challenging. To help, I scoured the Russell 2000 for small-cap stocks that could be perfect additions to portfolios in 2019. I ended up with an eclectic group of small-cap ideas that cut across sectors and investment styles.
Here's an alphabetical list of the 14 top small-cap stocks I think you can buy now, followed by a summary thesis for each idea.
1. Axos Financial (NYSE: AX)
2. Callaway Golf (NYSE: ELY)
3. Fastly (NYSE: FSLY)
4. Freshpet (NASDAQ: FRPT)
5. Inspire Medical (NYSE: INSP)
6. Instructure (NYSE: INST)
7. LivePerson (NASDAQ: LPSN)
8. OrganiGram (NASDAQ: OGI)
9. Redfin (NASDAQ: RDFN)
10. Rubicon Project (NYSE: RUBI)
11. Telaria (NYSE: TLRA)
12. Trupanion (NASDAQ: TRUP)
13. Upwork (NASDAQ: UPWK)
14. Walker & Dunlop (NYSE: WD)
What's the definition of a small-cap stock?
Small-cap stocks are stocks in companies that have a market capitalization of between $300 million and $2 billion. You can calculate a stock's market capitalization simply by multiplying the number of shares outstanding by its current share price, but you really don't need to. Most investment websites, including The Motley Fool, do the math for you.
If you're completely unfamiliar with or feel unprepared to dive right into small-cap stocks, you can learn more about their advantages, risks, and evaluation metrics by reading How to Invest in Small-Cap Stocks.
Why you should consider investing in small-cap stocks
The biggest reason to consider buying small-cap stocks is that historically, smaller companies have delivered higher returns to investors than larger-cap stocks. Small-cap companies can offer market-beating returns in part because of the law of small numbers. At a small company, even a minor increase in revenue can move the needle in terms of a percentage increase in sales or profit. Since share prices tend to follow earnings over time, this operating leverage can contribute to better returns.
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Also, small-cap companies often move faster than large-cap companies because they usually have fewer layers of bureaucracy, and they're less likely to be weighed down by existing, potentially archaic, processes and practices. For example, video conferencing company Zoom Video Communications' success stems from its ability to build its solution from the ground up rather than shoehorn features into existing platforms like older competitors, including Cisco Systems' Webex.
These advantages have translated into small-cap stocks rewarding investors with higher long-term average annual returns than larger companies. For comparison, let's look at two exchange-traded funds (ETFs): the iShares Russell 2000 ETF (NYSEMKT: IWM), which tracks a collection of roughly 2,000 small-cap stocks, and the S&P 500, which tracks 500 major mid-cap and large-cap companies on the market. From 2000 to 2018, the average return of the iShares Russell 2000 was 9.15% -- almost 2% better than the average return of the S&P 500.
Why small-cap stocks are risky
If you're interested in small-cap stocks, beware: With small-cap stocks' higher returns come greater risks.
- Higher likelihood for money troubles: Small-cap companies often have limited cash on their balance sheet relative to larger companies, and that suggests they're more likely to go bankrupt during tough times, when investors are less willing to buy newly issued shares and banks are reluctant to lend money at favorable interest rates.
- Deep-pocketed competition: Tight purse strings may also put small-cap companies at a disadvantage when larger foes decide to compete with them.
- Concentrated decision making: Furthermore, if founders and other insiders own shares, they can hold outsized sway in decisions because small-cap companies have fewer shares outstanding. Often, investing alongside investor-owners is a positive, but concentrated decision making can be a problem if changes in leadership or direction are necessary but insiders disagree with them.
- Lack of financial controls: There's also a greater risk that small companies lack adequate financial controls relative to big-cap stocks, which can result in performance-busting financial restatements or fraud.
- Low share volume creates volatility: Buying or selling small-cap stocks at favorable prices can also be tough. Small-cap stocks don't typically trade a lot of share volume every day, and that lack of liquidity can cause share prices to swing wildly. As a result, investors may not be able to buy or sell shares at favorable prices, crimping profits or causing wider-than-expected losses.
In short, small-cap stock investing isn't right for everybody.
Nevertheless, owning at least some small-cap stocks can be wise given their track record of outperformance. You won't be able to eliminate every risk, but picking disruptive companies with sales and earnings growth and diversifying across many stocks can limit those risks.
Which small-cap stocks are smart buys now?
There are thousands of small-cap stocks to choose from, but you can narrow your hunting ground by only considering those small-cap companies that are revolutionizing industries. Disruptive companies -- especially those targeting large or emerging markets -- share some common characteristics:
- Double-digit year-over-year revenue increases with plenty of room for additional growth
- Shrinking net losses and a path to profitability
- An increasing number of customers doing more business with them
- A competitive advantage
For instance, here's why the 14 individual small-cap stocks I highlighted at the beginning of this article could produce significant returns in the future.
1. Axos Financial
Axos Financial is at the forefront of a new generation of banks. In the past, banks connected with customers in person through local branches. That was expensive. Nowadays, banks are shifting their business online. However, many banks are still weighed down by legacy operations. That's not true of Axos Financial, formerly BOFI (Bank of the Internet). Built from the ground up for the Internet generation, Axos boasts more than $8 billion in deposits and profits from interest earned on more than $9 billion in loans. The company's net interest margin (the spread between funding costs and interest on its loans) and its efficiency ratio (operating costs as a percentage of revenue) are consistently among the industry's best. Lately, investors have gotten nervous that expenses from acquisitions are zapping profitability. However, that nervousness could be creating a great long-term opportunity to buy this bank on sale given that its price-to-book ratio (market capitalization divided by breakup value) is 1.6 as of July 2019, which is near a five-year low.
2. Callaway Golf
Callaway Golf is one of the best-known golfing brands. Equipment and golf balls account for more than 60% of its revenue, but acquisitions are pushing it deeper into golf apparel and accessories. For instance, its acquisition of Jack Wolfskin bolstered its presence in China and Central Europe in 2018. Deals like this increase Callaway's exposure to currency-exchange risk, but they should help the company capture more of the multibillion-dollar global golf market. As of March 2019, its revenue outside the U.S. accounts for more than half of its total sales. The company's gross margin (gross profit divided by total revenue) is firmly in the high 40% range, and Callaway is nicely profitable, with $90 million in trailing-12-month net income through Q1, 2019. Since Callaway's brand loyalty is high, it's growing faster than the industry itself. Granted, there's no guarantee that loyalty will continue, but if it does, you might be wise to add this small-cap stock to your portfolio -- especially since activist investors have emerged recommending shareholder-friendly changes.
Fastly provides an edge-cloud platform that helps speed up business applications. An infrastructure-as-a-service (IaaS) company, Fastly helps its clients deliver fast, secure, personalized experiences by moving the computer power and logic necessary for running apps as close to the client's users as possible. Its strategy is resonating. Online news services, including the New York Times, use Fastly to deliver content to viewers; Ticketmaster uses it to handle thousands of simultaneous requests for tickets; and Spotify uses it to delight its users with its entertainment catalog. Fastly's revenue grows as its clients' app usage expands, and its dollar-based net expansion rate was 132% in 2018. This existing-client growth plus the addition of new clients grew revenue 38% to $145 million in 2018. Considering that consumer expectations for speed and reliability aren't waning, Fastly's growth runway could be long.
Freshpet is disrupting the dog- and cat-food market with refrigerated, fresh food options sold in grocery stores, club stores, and pet stores by installing refrigerators that sell their own pet-food lines. It derives almost all its sales from North America, where the dog- and cat-food retail market is worth $30 billion and growing at a 6% compounded annual clip. As of March 31, 2019, Freshpet has installed fridges in more than 20,000 retail stores, an increase of 10% year over year. That higher installed base -- coupled with an increase in marketing -- has management estimating sales will increase 24% to $240 million in 2019, up from $152 million in 2017. That could be only the beginning. More than 80 million households own pets, and 95% of U.S. pet owners view their pets as family members. If pet owners embrace healthier nutrition options for their furry friends, increasingly more of the 300 million pets in America alone could become happy Freshpet customers.
5. Inspire Medical
Inspire Medical is tackling sleep apnea in an entirely new way. Instead of relying on masks that deliver airflow to sleeping patients to keep airways unblocked, Inspire has developed a minimally invasive device that stimulates a nerve to keep your tongue from blocking your airway while you're sleeping. Since many people are disappointed with existing continuous positive airway pressure (CPAP) machines, new options like Inspire's could win increasingly greater use as doctors and patients seek to reduce blood pressure, hypertension, heart failure, and stroke. The population of potential patients is big. As of August 2019, about 5,000 people have been treated with Inspire's device. However, there are roughly 17 million people in the United States with moderate to severe obstructive sleep apnea, and about 2 million are prescribed CPAPs annually. More than one-third of those CPAP patients don't use it as recommended. Inspire Medical's sales grew 61% year over year to $16.3 million in Q1 2019, and thanks to growing insurance coverage -- including a positive decision by UnitedHealth, the nation's largest insurer -- in July 2019, its revenue could continue climbing.
Instructure's main software-as-a-service (SaaS) product, Canvas, is best known to the higher-education audience; however, the company's newest product, Bridge, is beginning to establish a foothold in corporations too. Instructure's software is already being used by more than 4,000 colleges, universities, K-12 school systems, and companies to develop, deliver, manage, communicate, and track academic and employee development programs. These clients pay Instructure anywhere from thousands of dollars to several million dollars, and in 2018, its net revenue retention rate exceeded 100% thanks to high retention rates and expansion. Recurring subscription revenue represents 90% of the company's sales, which totaled $210 million in 2018, up 30% from 2017. Its addressable market in education alone exceeds $1 billion. Combined with its new corporate initiative, Instructure estimates its total addressable market exceeds $15 billion.
LivePerson markets tools that allow companies to connect with customers through mobile messaging via employees or artificial intelligence. Its solution leverages various messaging platforms, including Facebook Messenger, WhatsApp, and Alexa, to increase sales and customer retention. LivePerson's concept of "conversational commerce" is catching on. As of 2019, more than 18,000 businesses, including HSBC, Orange, and The Home Depot, are using LivePerson solutions, and in 2018, it recorded $249.8 million in revenue, up 14% from 2017. Looking ahead, a ramp-up in its sales force will increase expenses in 2019; however, management expects the higher headcount will translate into high-teens year-over-year growth exiting 2019 and 20% growth in 2020.
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OrganiGram should be at the top of any list of the best small-cap stocks to buy, because global trends toward marijuana legalization suggest it's only a matter of time before the $150 billion illegal marijuana market shifts from the shadows to legal, regulated businesses. For now, OrganiGram generates all of its revenue in Canada, where marijuana laws created a recreational-use marketplace in late 2018. It will take time for the legal Canadian marijuana market to mature, but illegal sales totaled about $5 billion in 2018, so the opportunity in Canada alone is significant. With plans for more than 100,000 kilograms of marijuana production exiting 2019, OrganiGram's net sales could expand substantially as new marijuana products are launched, more stores open, and more countries pass pro-pot laws.
Redfin is revolutionizing real estate. Instead of charging brokerage commissions of 3% on each side of the transaction (i.e., 6% total between buyer and seller), it charges a listing fee of merely 1% to 1.5%. And it offers buyers a rebate from its commission, too. That cost advantage is possible because Redfin has made big tech investments that allow it to sell homes faster and for more money. Its tools have turned it into the top real estate brokerage website in the U.S. In the future, Redfin's expansion plans include prepping homes for sale and buying properties for resale itself. Its revenue grew by a compounded annual rate above 30% from 2013 through 2018, yet its market share is still below 1%. With repeat business growing 35% year over year exiting 2018, new services launching, and increasing brand awareness, Redfin may be one of the best real estate stocks investors can own.
10. Rubicon Project
Rubicon Project is a Los Angeles-based, 400-person advertising firm that connects digital ad buyers with ad sellers across 30 global markets via an ad exchange. In 2017, competition caused it to eliminate fees to buyers, significantly reducing revenue. The decision took a short-term toll on its top line in 2018, but that has resulted in more ad spending on its exchange, which puts the company in a better position to deliver year-over-year growth now that future comparisons will be more straightforward. Rubicon's focus on facilitating access to consumers regardless of whether ads are mobile, desktop, television, audio, or something else entirely should help it capture more marketing spending as advertisers and publishers shift away from traditional methods of ad buying and selling. Management thinks its total addressable market will hit $84 billion in 2022, and as a result, the company is modeling growth of at least 20% annually.
Telaria is another company benefiting from the shift of ad dollars into digital media, but unlike Rubicon, it's carving out a niche by allowing publishers of online video content to make the most money off their ad space. Its digital video solutions address mobile, over-the-top, and connected TV (CTV) content. CTV, or the use of devices that directly connect televisions to the Internet, is particularly interesting because it's one of the fastest-growing areas of video content. For example, Telaria's revenue generated on CTV devices increased 322% year over year to $14.8 million in 2018, and as of March 2019, it accounted for about one-third of Telaria's revenue. As more ads shift to programmatic or automated systems, the need for Telaria's analytics and ad management tools should increase, allowing it to capture an even greater share of this market.
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Trupanion is bringing pet health insurance to the masses. It's a good business to be in. Growing pet ownership, healthier pet lifestyles, and an increasing view of pets as family members are causing demand for pet insurance to soar. Trupanion sells plans directly to pet owners via subscriptions, and it offers programs through employers that provide pet insurance to employees as a perk. Its retention rate is above 98%, and as of March 31, 2019, about 550,000 pets were insured by products it sells directly or through third parties that private-label its insurance plans, up from 383,000 in June 2017. In 2018, revenue increased 25% to $304.0 million. Given that there are about 180 million cats and dogs in U.S. households, this company may only be scratching the surface of a truly massive market.
Upwork connects businesses with freelance contractors, capturing a small percentage of the freelancer's income for its troubles. A gig-economy pioneer, it competes against companies like Fiverr; however, it is the largest player in this marketplace, having processed $1.76 billion in gross services volume in 2018, which was more than five times higher than Fiverr. In 2018, its average "take rate," or the percentage pocketed for each dollar paid to freelancers, was 14.4%, down slightly from 14.8% in 2017. The compression should be watched, but because the average client is spending more money on its platform, revenue still grew 25% year over year to $253 million in 2018. Since the number of core clients hunting for freelancers is increasing and more workers are looking for flexible work alternatives, Upwork's sales should continue growing.
14. Walker & Dunlop
Walker & Dunlop is a commercial real estate lender and broker focusing on multifamily housing. Its market capitalization may be small, but it's a giant in its industry. It helps clients secure Fannie Mae, Freddie Mac, and HUD financing, then it sells and services those loans for a fee. Sometimes it provides bridge loans until other financing is secured. Other times, it invests alongside its clients. Its commercial and multifamily servicing portfolio grew 15% year over year to $86 billion in 2018, making it the seventh-largest player in this industry nationally by size, according to the Mortgage Bankers Association. Its revenue only inched up 1% to $725.2 million in 2018, but adjusted earnings grew 6%, and management is ramping activity to get to $1 billion in revenue in 2020. If it delivers on that promise, shares could march nicely higher, but even if they don't, investors will still benefit from its 2.2% dividend yield.
Randi Zuckerberg, a former director of market development and spokeswoman for Facebook and sister to its CEO, Mark Zuckerberg, is a member of The Motley Fool's board of directors. Todd Campbell owns shares of Facebook, iShares Russell 2000 Index, and OrganiGram Holdings. His clients may have positions in the companies mentioned. The Motley Fool owns shares of and recommends Axos Financial, Inc., Facebook, Trupanion, Walker & Dunlop, and Zoom Video Communications. The Motley Fool owns shares of Inspire Medical Systems, Inc., and Spotify Technology. The Motley Fool recommends Instructure, LivePerson, OrganiGram Holdings, Redfin, The New York Times, UnitedHealth Group, and Upwork. The Motley Fool has a disclosure policy.
This article was originally published on Fool.com