It's Time To Buy The Small Cap Losers Of 2018 For Gains Into 2019

Summary

• It's time to go bargain hunting and accumulate beaten down small cap stocks that can rebound in late December and into January.
• Small cap stocks could be poised for a big rally into year end according to a JP Morgan analyst.
• Tax-loss selling pressure will fade by around mid-December and that is when big rebounds could start occurring.
• Short-sellers who are trying to put off creating taxable gains until 2019, could cause buying pressure as they cover in early January.

At this time of year, it makes sense to start buying beaten-down stocks that are undervalued and being temporarily depressed by tax-loss selling.

Each year I focus on this strategy and after much research, I have found a number of stocks that appear poised for a strong rebound as we get closer to the end of December. Based on my experience, tax-loss selling tends to peak in mid-November and then starts to taper off after the first week of December. Because of this, it makes sense to start accumulating shares now, and of course buy on any dips for the next three weeks or so. Most investors and fund managers have completed selling stocks for tax-loss reasons before the holiday season and for this reason, many beaten down stocks start to rise around mid-December. That's why it makes sense to start buying now and continue accumulating over the next couple of weeks. I expect many of these stocks to start rising by mid-December and then see further gains into January. The end of tax-loss selling removes the temporary excess supply of shares being sold in December, and then there is often a wave of buying in early January that comes from short sellers who are doing their own tax moves by trying to wait to cover their positions in early 2019. By doing this, they can postpone taxable gains for another year.

The combination of the end of tax-loss selling in December along with short sellers buying to cover in early January can lead to some sharp rebounds, especially in small cap stocks which usually get punished the most by tax-loss selling since these stocks are not as liquid and therefore cannot absorb the extra supply of stock as easily as large cap stocks. Due to lower volumes and liquidity, the smaller cap stocks and some mid cap stocks tend to rebound more sharply (compared to large caps) in early January when there is new buying pressure that can come from short sellers who are trying to cover their positions. For these reasons I tend to focus on buying beaten-down small and mid cap stocks that are most likely to see these sharp rebounds.

Marko Kolanovic, the global head of quantitative and derivatives research at JP Morgan (JPM) who is widely followed, is forecasting a year-end rally that he believes will be led by small cap stocks. Small cap stocks are typically defined as being companies that have a market cap of less than $2 billion. When evaluating these stocks, it is worth considering this: if these stocks can trade for X dollars per share right now, even with heavy tax-loss selling pressure, just imagine what they could trade for when tax-loss selling pressure has ended and when a large number of short sellers could potentially be covering in January. With this in mind, here are some of my top stock picks to buy now for potentially meaningful gains into 2019 which is fast approaching:

McDermott International (MDR) is a construction and engineering firm that specializes on energy industry projects. This company operates in 54 countries and it handles complex projects for some of the largest companies in the world. For the third quarter of 2018, this company reported revenues of $2.29 billion and earnings of 20 cents per share, which missed the analyst estimates of 29 cents per share. This caused the stock to drop to about $8 per share, and it now looks like an ideal opportunity to buy cheap. The stock price decline appears to be an overreaction and it is important for investors to remember that it does not make sense to read too much into a single quarter. That's because delays or completion of a major project depends on timing, and that can make for some lumpy earnings results. For example, for the second quarter of 2018, analysts were expecting earnings of just 15 cents per share, but McDermott posted a profit of nearly double that figure at 29 cents per share.

McDermott shares were trading for about $18 in early October but the decline in oil prices during the month caused most energy related stocks to drop as well, and this helped take the stock down to around $13 per share. However, the earnings report caused another drop in the stock and it currently trades in the $7 to $8 range. This looks incredibly undervalued especially since analyst estimates are at 90 cents per share for this fiscal year and $1.62 per share for next year. That puts the forward price to earnings ratio at just about 5 times, in a market that is trading for around 15 times earnings. The average of all analyst price targets amounts to $14.58 per share and this implies significant upside potential. It is worth noting that McDermott shares were trading for more than $14 per share as recently as October, so it would be no surprise to see the stock back at those levels in early 2019, especially if oil prices stabilize or start to move up which could have already started to happen. Mark Fisher who is a well-known energy trader recently said the worst is over for oil and it is time to buy. I agree that oil itself and energy stocks are oversold and could be due for a rebound.Backing up my belief that the selloff in this stock has taken it to bargain levels, multiple insiders have recently bought a significant amount of shares. Just after the earnings report was released, Gary Luquette (Chairman of the Board of Directors), purchased about $500,000 worth of McDermott stock. David Dickson (President and CEO) purchased about $400,000 worth of McDermott stock and Stuart Spencer (Executive VP and CFO) purchased about $250,000 worth of McDermott stock.

Hennessy Advisors, Inc. (HNNA) is an investment management firm, offering a wide range of equity funds under the "Hennessy Fund" brand. This company is based in California and its founder Neil Hennessy and other executives from the firm are regularly appearing as guests and contributors at CNBC, Fox Business, Bloomberg TV, The Wall Street Journal, Barron's and other media outlets. Mr. Hennessy has been ranked in Barron's Top 100 Mutual Fund Managers for many years and the company has grown rapidly since it was founded in 1989.

This rapid growth has allowed the company to consistently raise the dividend. On October 30, 2018, Hennessy Advisors announced another dividend increase of 10% which takes the quarterly payout from 10 cents to 11 cents per share. With a 44 cent per share annualized dividend, the stock yields about 3.5% and with earning estimates of more than $2 per share, the payout ratio is low which means there is plenty of room for the company to keep raising it. This firm has increased the dividend every year for the past 13 years so it seems very committed to a having a dividend growth policy. Another positive is that about 41% of outstanding shares are held by insiders. This means Neil Hennessy and others on the management team are very much aligned with shareholders.

According to the data on Marketwatch.com, there is only one analyst covering this stock and they have a buy rating along with a $20.25 price target. The analyst expects earnings of $2.13 per share for this fiscal year and $2.23 per share for next year. With the share price currently beaten down to just about $11, this implies the stock is significantly undervalued with a price to earnings ratio of just around 5 times earnings. The stock market has not been kind to financial industry firms and banks for the past few months, but with larger investment management firms like T. Rowe Price (TROW) trading for about 13 times earnings, the decline in this stock has gone too far and it does not deserve to trade for just about five times earnings. If anything, shares of Hennessy Advisors should trade at a premium in terms of the price to earnings ratio when compared to larger firms because it is growing at a faster rate and so is the dividend. If Hennessy Advisors were to trade for about 13 times earnings, the share price could rise to nearly $30. In the meanwhile, investors will collect a generous and growing dividend.

It is worth noting that with this firm trading at such undervalued levels, it is possible that it could be an ideal takeover target for a larger company or for a private equity firm. Hennessy Advisors has a current market cap of about $100 million, and with the firm managing about $6.4 billion in assets, an acquiring entity could take control of a very significant amount of financial assets for a relative pittance.

YRC Worldwide (YRCW) is major freight company in the U.S. and the stock looks very cheap after a recent selloff. I recently wrote about another freight company, U.S. Xpress Enterprises Inc. (USX), so there appears to be some bargains in this sector. U.S. Xpress shares went up about 10% after I wrote this article but due to volatile markets, the stock is trading at a bargain level again of just around $7 per share. I also believe YRC Worldwide will soon rebound from the very cheap valuation it currently sells for at less than $6 per share. Another factor that investors should consider is that U.S. Xpress and YRC Worldwide could be takeover targets, especially now with the shares trading at such undervalued levels. The Wall Street Journal has reported that XPO Logistics (XPO) is actively considering about a dozen buyout targets in the trucking and freight industry and the company plans to buy one or two companies. Of course there are also other large freight companies that could be looking to make acquisitions. There have been reports that Amazon.com (AMZN) is seeking to buy a freight company in order to increase its delivery capabilities. The Wall Street Journal article states:

"Mr. Jacobs said last year that XPO was prepared to spend up to $8 billion on big deals largely aimed at expanding its existing lines of business. The company has offered few specifics since, although Mr. Jacobs said in a May earnings call that XPO was on track to announce “a big acquisition or two medium-sized acquisitions” at some point this year."

A buyout of either U.S. Xpress or YRC Worldwide would be great for shareholders, because a deal would likely create very strong gains from these very undervalued levels. However, even if these companies were not acquired anytime soon, any buyout deal in this sector would likely boost stock values across the board. Furthermore, I am not buying these for buyout potential, even though it could be a major added bonus. I am buying these stocks because I believe both will see sharp rebounds once tax-loss selling is over and also because industry fundamentals remain strong.

As you can see in the chart above, this stock was trading for about $10 per share in September but the market correction in October and a weaker than expected earnings report took the share price down below $6. This pullback seems way overdone for a number of reasons. First of all, the Federal Reserve seems to be more dovish about raising interest rates than they were in early October which helps to ease the risk that aggressive rate hikes could push the economy into a recession. Another factor that has hurt the trucking sector is the shortage of drivers, and that impacted revenues and earnings for YRC Worldwide. However, they have stepped up recruiting and this issue is likely to be only temporary in nature. Finally, it is worth noting that oil prices have dropped significantly in the past 3 weeks and that is a big positive for freight companies since fuel is one of the largest expenses. The even bigger positive of lower oil prices is that it is a positive for the entire economy that businesses and consumers benefit from and that can lead to more goods being shipped.

Analysts expect YRC Worldwide to earn about $1 per share for next year and that puts the price to earnings ratio at less than 6 times earnings. Furthermore, the average analyst price target is $10 per share, which implies potential upside of almost 100%. The $10 price target also does not seem to be much of a stretch since that is roughly what the stock traded for just a few weeks ago and it is far less than the 52-week high of $17.61 per share. With the share price so beaten down in the last few weeks and with it trading for just a fraction of the high, there is no doubt this stock has been experiencing tax-loss selling pressure. If this stock is trading for just over $5 per share in the midst of tax-loss selling pressure and short selling, just imagine what it might trade for in late December to early January when tax-loss selling comes to an end and also when some shorts are likely to cover.

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Data is sourced from Yahoo Finance. No guarantees or representations are made. Hawkinvest is not a registered investment advisor and does not provide specific investment advice. The information is for informational purposes only. You should always consult a financial advisor.

Analyst’s Disclosure: I am/we are long USX, MDR, HNNA, YRCW. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.