Stocks and Markets Podcast: Why Now is the Time to Buy High-Yielding Small-Cap Stocks

This article is based on TheStreet's Stock & Markets Podcast. Hosted by the veteran Wall Street investor Chris Versace, the weekly podcasts are available early to members of TheStreetPro investing club.

York Water (YORW) has been going with the flow for more than 200 years.

The company, founded in 1816, is the oldest investor-owned utility in the U.S. and the first to pay investors consecutive dividends.

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Founded by a group of York, Pa., businessmen who were concerned about fire protection, York Water Co. was a focus of the July 9 edition of TheStreet Stocks & Markets Podcast.

Chris Versace, lead manager of TheStreet Pro's Portfolio, and TheStreet Pro’s Louis Llanes, senior vice president and wealth adviser at Farther Financial, spoke with Thomas Browne, a portfolio manager of small-cap and midcap stock funds at Gabelli.

The key focus of the discussion: small-capitalization stocks and dividends.

Small-cap stocks represent companies with market capitalizations typically ranging between $250 million and $2 billion.

Fund manager Browne: Small caps outdo S&P 500

Due to limited analyst coverage and fewer institutional investors who buy small-cap stocks, these equities may be less efficiently priced. Saxo Bank Group says that “provides an opportunity for savvy investors to identify undervalued stocks that could grow significantly once the broader market recognizes their potential.”

“It's fun to talk about small-cap stocks, although sometimes I feel like we're the only people who are talking about small-cap stocks,” Browne said. “It's been a long time since there was a lot of attention paid to them. But I think that we're going to have our day and it's coming soon.”

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“So now what makes you think that?” Versace asked. “But of late there seems to be a lot of focus not even on large-cap stocks, really on these megastocks that have been driving the S&P 500 [and] the Nasdaq. But what gives you hope that these other strategies will come back into favor?”

“I think that if you look over the long term — it is more than the last year or two, or five or even 10 — small-cap stocks have outperformed,” Browne said, noting that the S&P 500 trades at around 23 times earnings, while small-cap and midcap stocks trade around 16 or 17 times earnings.

“So you've got one group of stocks that is very highly valued well above the long-term averages, and another group of stocks that is valued significantly below their long-term averages,” he said.

“So it seems to me like over time — and it's not going to be this quarter; it may not be this year; it may not be the next two years — that has to come back to the averages.”

“The real issue is the expectations of growth,” Llanes said. “We even have almost negative expectations of growth in the small-cap stocks. We have a huge divergence between the expectations.”

More industrial investment in the US? ‘In spots'

“And there's a lot of divergence in the small-cap area between high-quality companies and low-quality companies,” he added. “And selectivity is important. But it just seems a little out of whack to me — or a lot out of whack to me.”

Browne said that few people look at the dividends in small-cap companies, despite groups like York Water or American States Water (AWR) , which at 70 years has the longest history of raising its dividend consecutively.

“If you look at the Russell 2000, it actually yields more than the S&P 500 today,” he said. “So, despite all these really positive attributes, people don't look at dividends, generally speaking, in small- and midcap stocks.”

Llanes said that he thought the markets were going to go through “a digestion period of the new tax rules and how that's going to impact things.

“And foreign policy is really affecting a lot of things for a lot of investors, whether it be in the private markets or in the public markets.”

With the Trump administration's tariff policy aimed at reshoring manufacturing back to the U.S., Llanes asked Browne whether he saw any increases in industrialization investment in the U.S.

“In spots,” he said. “You are seeing big companies announce projects here in the United States. And we have investments in some companies that are in the construction business who will help those companies build new factories in order to produce in the United States.”

“You've also seen a lot of talk about data-center buildouts, and that's going to require power,” Browne added. “That's going to mean construction of power plants. And so companies that are involved in building those factories and those data centers and the electricity sources to power them — [there's] clearly a good outlook for those.”

4 key holdings at funds Browne manages

Versace asked Browne to discuss some of the prominent holdings in the funds he manages. Here are some of the points he made:

Molson Coors (TAP) “has been through a multiyear restructuring where they've significantly improved the profitability. … [If] you look at the valuation of Molson Coors relative to other brewers, [there's a] huge discount that eventually we think has to close in some form or fashion.”

Gen Digital (Norton LifeLock) GEN “has made some good acquisitions over the last couple of years to really consolidate the personal online protection market. And so they have a strong position there. It's not a fast-growing business. It's low- to mid-single-digits, hugely profitable and trades at a really cheap price.”

Ensign Group (ENSG) “is probably the best-run of the skilled nursing facility companies, … and their focus is on skilled nursing as opposed to assisted living. That's an area that due to an aging population is going to continue to grow.”

Wintrust (WTFC) “is a bank here in Chicago who is another very good acquirer and runs the business very well. Great on credit. Really good at making loans. And it trades at 10 [or] 11 times earnings.”