Small-Cap Bull Market Just Getting Started

The Russell 2000 has been surging, but the move looks nowhere near done

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Apr 28, 2016
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Over the long-term stocks beat bonds, bonds beat cash, and inflation is a truly destructive force. Ibbotson’s numbers, covering 1926 through 2014, show that small stock returns significantly beat those of their larger brethren.

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Based on my own cost of living I’d say the official BLS inflation numbers might better be labeled as BS. Since the Federal Reserve Bank took over the mandate of “price stability” in 1913, the U.S. dollar has lost almost 96% of its purchasing power.

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Smaller company stocks hit bottom in February. They’ve been on fire since. Based on the past history of the Russell 2000, the fun may be just getting started.

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I’m not just starting to tout this theme. See my earlier GuruFocus article on this topic for details.

Carpet tile manufacturer Interface (TILE, Financial) caught my eye as a value play recently. The firm made a lot of fundamental progress from 2012 through 2015. The stock paralleled the trends. Interface moved from under $11 in 2012 to a peak north of $27 last August.

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Enigmatically, as of April 27, the shares were again available in the $17 range, about 36% below its old high. The company reported first-quarter numbers after the close, beating both last year’s figures and analyst estimates.

The stock’s P/E is now lower than it sat on three of the four "best buying opportunities" since the start of 2011 (green-starred below). It was briefly cheaper only during February’s panic selling. The current yield of 1.16% is well above the firm’s average payout of 0.70%.

When Interface was in favor, it topped out (red-starred) between 24x and 34x forward estimates. Interface’s most recent half decade saw it command an average multiple north of 24x.

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A regression to a more typical valuation could easily support a 12-month target price in the mid-$20s, implying upside of 40% or better. That is far from crazy. Interface broke $20 back in 2011 on EPS of just 66 cents when the dividend was 8 cents. It traded above $22 during both 2013 and 2014 on similar earnings.

Willing to accept less upside while getting a nice extra margin of safety? Consider selling some near-the-money Oct. 21, 2016, expiration date $17.50 strike price puts. I got $2.15 per share for those on Wednesday, dropping my "if exercise" cost to just $15.35.

If Interface merely nudges up past $17.50 by October my best-case result on this put sale will be keeping 100% of the premium received. My worst-case result would be forced purchase at a price rarely available during the past three years.

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Either of those outcomes would be fine by me.

Buy some Interface shares, sell some puts or do both. It’s a great way to play the trend toward small-caps and might well pay off bigger than simply owning a fund or ETF. Interface’s 1.3 beta means it moves more sharply than the market in general. That’s a good attribute when shares appear depressed and are likely to rise.

Disclosure: Long TILE shares, short TILE options.