Growth Stocks Down. Small-Caps Are Worse. Could This Be Time for Small-Cap Growth?

If all else fails, there’s Cathie Wood’s

ARK Innovation
exchange-traded fund (ticker: ARKK), down two-thirds from its high, and if you’re doing worse than that, kindly go into fund management to give the rest of us something to feel better about.

Somewhere in this who’s who of what’s worse, the natural order of finance recently got jumbled. Among small companies, growth stocks have become cheaper than value ones. “That’s kind of head-scratching,” says Brad Neuman, director of market strategy at Alger, a growth manager overseeing more than $35 billion.

Neuman cites the

S&P SmallCap 600,
which doesn’t go quite as small as the Russell 2000, and so tends to track companies with sturdier finances. Its growth component recently traded at 12 times this year’s projected free cash flow, versus 15 times for value.

Stocks have never divided perfectly into growth and value buckets, because most companies are meant to grow, and value is subjective. Rule of thumb: If you’re embarrassed to name the company but are proud of the price you paid, it might be a value stock. The opposite goes for growth.

Neuman says a growth premium is typical and well-deserved. These companies can offer rapid revenue gains, high returns on incremental capital they put to work, attractive gross margins, and modest debt.

So what’s gone wrong? Rising rates turned investors from feverish to cool on pricey growth shares. But much of the excess might be undone. Across large companies,

J.P. Morgan

calculates that growth stock valuations have fallen from the 97th percentile last November to the 53rd recently—in other words, from extraordinarily expensive levels to near parity with value.

Meanwhile, small-caps recently hit the valuation low point they touched in 2009, during the global financial crisis. J.P. Morgan has a theory on that. Big companies have spent furiously on their own shares this year. Outlays could reach a record $600 billion during the first half. Small companies tend not to spend much on stock buybacks, so their shares have gotten less support.

Neuman sees growth stocks returning to form this summer. He says interest-rate hiking cycles tend to start when the economy is running hot and end after it cools. So value stocks, which tend to be more closely tied to economic than growth cycles, often outperform a few months before and after hikes begin. This time, the Federal Reserve began raising rates in March.

We’ll see whether that prediction works out. Investors who want to add exposure to small-cap growth stocks can use index funds like

Vanguard Small-Cap Growth
(VBK) or active funds like

Alger Small Cap Focus
(AOFAX).

I asked Neuman for his favorite stocks. He mentioned three cloud-software outfits that have plenty of subscription revenue and close integration with customers.

Avalara

(AVLR) helps companies comply with complex tax rules for goods they source and sell around the world. Free cash flow is minimal, but he says high gross margins, rapid sales growth, and a large potential market are signs free cash can ramp up quickly.

Bentley Systems

(BSY) sells software that engineers use to model complex infrastructure, like liquefied natural gas plants. And

Guidewire Software

(GWRE) has data, analytics, and artificial intelligence used by hundreds of insurance companies to price coverage.

Here are some tidbits from recent conversations that don’t go together neatly. I believe the restaurant business calls this approach the mixed grill.

Broadcom

(AVGO) plans to buy

VMware

(VMW) for $61 billion, we learned this past week.

UBS

chip analyst Timothy Arcuri, a Broadcom bull, says that will bring its chip revenue below 50%, which could be well timed if the chip cycle rolls over. Rolls over? What about chip shortages? There are signs chip inventories are growing, and “it’s sort of impossible to manage perfectly,” says Arcuri. If consumer demand sags, the industry could skip from shortage to glut. Favor companies that can grow in nascent markets, he says, like

Nvidia

(NVDA), which is well positioned in virtual reality.

Snap

(SNAP) stock plummeted 43% this past Tuesday after management suddenly soured on business conditions. That’s a sign that broader demand for advertising could take a hit, says Lloyd Walmsley, also at UBS. Ad buyers are likely to shift dollars from smaller venues to more reliable ones like

Facebook

and Google by next month, but by the third quarter, the giants could come under pressure, too, he says. Some of that is already reflected in share prices. He calls Facebook owner

Meta Platforms

(FB) controversial but also “incredibly cheap,” and calculates that

Amazon.com

(AMZN), a small but rising ad player, trades slightly below the value of its cloud business, meaning investors, in his view, get the retail side for free.

Thomas Peterffy is the 77 year-old founder of

Interactive Brokers Group

(IBKR), and controls more than 70% of the stock. IBG has fared far better than

Robinhood Markets

(HOOD) during the downturn. Peterffy says that’s because IBG’s market-maker roots have left it with sophisticated traders as clients, who are willing to pay commissions when other brokers offer zero-commission trading and make money routing trades to venues that pay.

The industry line is that so-called payment-for-order flow leaves customers no worse off. You wouldn’t know it talking to Peterffy, whose company has its own zero-commission service for infrequent traders called IBKR Lite. “I don’t think it’s good for the customer, but it doesn’t make too much difference,” he says of order-flow payments. “We’re talking about pennies.”

Write to Jack Hough at [email protected]. Follow him on Twitter and subscribe to his Barron’s Streetwise podcast.