3 in 3: Small Caps’ Window, Energy’s Edge, Defense’s Disconnect

Small caps just got cheaper, energy is working overtime, and defense companies are winning some of the biggest contracts in years. 

I'm Jim Lydotes, and these are our three points in three minutes. So let's flip over the timer and let's go. 

The US small cap index looks expensive at a headline level. And through the end of August, it was trading at about 28 times forward earnings, which is about a four-term premium to its five-year average. But just looking at that headline misses three very important things. First, that five-year average includes the rate shock that we saw in 2022. So if you take that as an outlier and you strip out that one year, today's multiples are roughly in line with where we've been historically. Second, the fundamentals are really good here. We just got through earnings, and two-thirds of small cap companies beat street expectations. And that's the highest that we've seen in over five years. And finally, small caps just got cheaper after pulling back in late August. So that combination of the business is doing really well and the recent pullback could be a good setup if you're looking for entry points into small caps. 

Energy's been the best performing sector this year, and that's true in large caps as well as in small caps. But even still, of all the sectors in the SP, energy still trades at the lowest multiple on an EV to EBITDA basis and it also carries with it the highest free cash flow yield. So we've got something you rarely see: a sector where the earnings yield is higher than the EV to EBITDA multiple. This group is generating a lot of cash right now, and a lot of that cash is making its way back to shareholders in the form of dividends and buybacks. Uncertainty raises the risk premium in oil, which is good for energy companies, but uncertainty also raises the importance of cash coming back to shareholders, which right now also favors energy companies. The sector has performed so well so far this year, but we see lots of reasons for that to continue. 

Over the last several weeks, we've seen some of the largest defense contracts we've seen in years. But defense stocks just aren't responding. Through August, broad markets are up year to date, the industrial sector up year to date. But defense stocks, if you can believe it, are down. If you've got some patience, we think this is a really good time to be leaning into the group, which is what we're doing right now. There's some concern in the near term that some of these higher manufacturing costs could bring some margin pressure. But these contracts aren't one to two year wins. Some of them are gonna lock in work for the next decade. So the backlog is building, but the stocks just haven't reacted. And eventually one of those things is going to have to change. So that's our three points in three minutes with a little sand left in the bottle. Have a great week and we'll see you back here next time.

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