There’s a lot of chatter on Wall Street about artificial intelligence replacing analysts — the folks at banks and brokerages who tell investors which stocks to buy, hold or sell. The bots should be able to make those recommendations just as well as humans. More consequentially, they should also be able to cover a broader range of stocks.
The bots aren’t here yet, however, and in the meantime, hundreds of US public companies are mostly ignored by analysts. That raises the tantalizing possibility that investors might find a hidden gem among overlooked companies — the proverbial great business at a great price. They’re normally hard to find, analyst coverage or not, because the market generally sees to it that investors get what they pay for.
But there are more high-quality companies selling at bargain prices than usual, seemingly because fewer investors are looking for them. About a quarter of the roughly 4,000 stocks in the Bloomberg US Aggregate Equity Index receive little or no analyst coverage, almost all of them smaller companies. That isn’t new. What is new is that analysts are paying more attention to the biggest companies.
Much of the obsession with the Magnificent Seven, the largest US public companies by market value, is warranted. As a group, they are among the most reliably efficient money-making machines ever assembled. The same can’t be said about the rest of the market — particularly where smaller companies reside — which is increasingly becoming a dumping ground for businesses too precarious to attract capital elsewhere.
Nearly half the companies in the Bloomberg US 2000 Index, which includes the largest 1,001 to 3,000 public companies by market value, lost money last year. This year, analysts expect the index to achieve a return on equity, a common measure of profitability, of just 0.8%. That compares with an expected ROE of 32% for the Mag 7 and 15% for the other US large caps. It’s no wonder many investors think bigger is better.
Hiding in that aggregate data, though, is a surprising number of solid businesses trading at good — and possibly great — prices. I sorted the companies in the Bloomberg aggregate stock index for which data is available — about 3,100 of them — by an equal-weighted blend of three widely used markers of quality: return on equity, total debt to equity, and variability of earnings growth.
I then separated them into three groups of large, mid and small companies based on their market value and compared the 100 highest quality companies in each group. The quality scores for large and mid-caps were only modestly higher than those of small caps, but their valuations varied considerably. The large cap group trades at a median of 23 times trailing 12-month operating earnings, compared with 17 times for the mid-caps and just 11 times for the small caps.
That degree of valuation disparity among large and small companies of comparable quality shouldn’t exist in a highly efficient market like that of the US. It’s a rare enticement to look beyond household names such as Microsoft Corp. and Alphabet Inc. — both of which made my cut of the 100 highest-quality large caps — and into the sea of unheralded businesses that trade in the market.
I get that most investors don’t have the time or inclination to dive into stock charts looking for high-quality bargains. One alternative is to look for low-cost funds that target small companies with the best combination of quality and value. And when deciding how much to invest, bear in mind that small caps account for just 6% of US stocks by market value; most investors will do well to target an allocation that approximates that.
The deals in small cap land won’t last forever. But until the bots are deployed, and while investors are fixated on the Mag 7, the adventurous should find plenty to like there.
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