In a stock market that favors the giants, it's still possible to reap big gains investing in Wall Street's small fries.
The winning formula? Find small-cap stocks that have peppy and sustainable growth potential as well as management teams with a knack for putting up better earnings and sales numbers than Wall Street expects. And if these small caps fly under the radar of the investing herd and are under-owned, all the better.
That's the winning blueprint for Brandon Nelson's $406.5 million Calamos Timpani Small Cap Growth fund (CTSIX).
The fund posted a 19.2% return in the past year ending Feb. 28, topping 98% of its peers. Plus, its five-year annualized gain of 10.7% and 10-year return of 9.2% bettered seven out of 10 funds in its category.
How This Fund Looks To Beat The Stock Market
Nelson looks for companies with fundamental momentum and an underestimated growth trajectory.
"We don't just want a fly-by-night company that is going to have good growth for one or two quarters," Nelson told IBD. "We want to see a sustained growth profile where they've got something special, some sort of unique service or good that they're selling that has a long tail to it."
Nelson buys stocks that are gaining share and have a competitive edge. He looks for small-cap stocks that might have 2% market share today with the potential to grow that market share to 8% or 10% in a few years.
Winning Higher Valuations
The manager of Calamos Timpani Small Cap Growth also likes stocks with the potential to see their valuation rise when the market finally recognizes their sustainable growth profile. For example, a stock he buys might have a price-earnings ratio of 15 when he starts building a position but has a good chance of getting re-rated higher to say, 30 times earnings or something much higher, three to six quarters later.
He'd rather buy a stock whose management team estimates will grow earnings 22% but beat to the upside on earnings reporting day than a stock with forecast growth of say, 43%, but that risks falling shy of expectations.
"That's sort of the ideal setup," said Nelson. "We like companies that put up nice upside surprises."
Sticking To Stock Market Rules
This stock-picking discipline points him in the direction of stocks with upside momentum.
One stock that fits the bill is Rush Street Interactive, an online gambling and sports-betting company with a $1 billion market cap. He calls online casinos a "megatrend," and notes that two-thirds of Rush Street's revenue comes from online casino gambling, such as slots and blackjack, which he believes is a better business than sports betting.
Sports gambling is being legalized in more U.S. states and online casino gambling is also on the rise at the state level, albeit at a slower pace, he says. And the push to legalize online gambling abroad is also gaining converts.
"Legalization is going to continue to tick higher," said Nelson. "So, it's a huge market. And Rush Street has unique technology and features, such as player bonuses and bettor interactions, that they utilize to enhance the gambling experience for the user. That creates a stickiness for the players."
Betting On Battling Diseases
Another small company with a long growth runway, he says, is ADMA Biologics. The health care company, which has a market value of $3.9 billion, sells plasma-based biologic drugs used to treat patients who have immune deficiencies. The company's fastest-growing drug and largest part of its revenue stream is Asceniv, which prevents infection in patients with hyper-immunodeficiency issues that are prone to infection.
Currently, there are about 25,000 people who suffer from this acute form of immunodeficiency, but Asceniv currently treats 1,000 of them. "They can't make this stuff fast enough," said Nelson. "They've only tapped into a small percentage of the patients that could really use the product. If they could make more, they would sell more.
The drug requires a special form of "high octane" plasma that only about 10% of blood donors have, says Nelson. "It's a supply issue, and they're working on addressing that," said Nelson.
To boost manufacturing constraints, ADMA Biologics is working to boost capacity by improving and optimizing the efficiency of their 10 existing plasma manufacturing and donation sites as well as tapping additional sources of plasma.
Nelson likes their sales visibility. The company forecast sales of $420 million in 2024, $485 million this year (+15% year-over-year growth), and $600 million in 2026 (+24%), says Nelson.
Checking The Boxes To Beat The Stock Market
Another small health care stock in the fund's top 10 holdings is GeneDx Holdings. "This is another stock that checks the boxes," said Nelson. "It's in its early (growth) days."
The company sells diagnostic testing equipment that identifies rare diseases in children, such as epilepsy and cerebral palsy, to name a few. They are rolling out new tests that target different rare diseases and new products used in neonatal intensive care units. "(Those are) going to be additional growth drivers," said Nelson.
Best Mutual Fund Goes To Learns New Skills
Nelson has also gone to school on another small stock in the for-profit education space: Lincoln Educational Services. The company, which as a market cap of $578 million, serves a key slice of the educational space: an alternative to traditional four-year college degrees with an emphasis on professional trades such as auto mechanics, welders, electricians, as well as health care related training for future dental assistants and nurses.
These one-year programs train skilled workers and tuition costs are reasonable, says Nelson. And Lincoln Educational Services is a leader in the field and is growing and adding new campuses.
"It's a midteens growth company with a knack for beating expectations," said Nelson. "It's still fairly undiscovered."
Another education play Nelson likes is Stride, a for-profit at-home learning company. Learning from home is on the rise post-Covid. "Bullying is a big reason too," said Nelson, referring to the trend of kids being home-schooled to avoid getting picked on in the classroom. Add in a growing dissatisfaction with the current state of education, and the opportunity is huge, Nelson says.
"Parents and students want more options, and this is one option," said Nelson.
Strong Demand For Education
Enrollment trends are strong, and the stock is still inexpensive, says Nelson. "It's a one-off that is probably not very well-owned," said Nelson. "It's a stock that not a lot of people talk about. And it's got room for valuations to continue to expand."
The company could benefit from less regulation from the Trump administration as well as laid off federal workers looking to gain new skills to find new work opportunities after being let go in the federal government's downsizing effort.
Overall, Nelson likes the setup for small-cap stocks. He notes that small companies are poised for gains in large part due to the fact that they've been laggards in recent years vs. large caps. And as a result, they are selling at more attractive valuations.
The catalyst to jump-start small-cap stock prices is an expected acceleration in earnings. "For the first time in years, small-cap profits are actually accelerating," said Nelson. The spike in earnings, he says, will be driven by weak year-over-year comparisons, (President Donald) Trump's growth-focused policies, as well as less regulatory headwinds.
Nelson also expects large companies in search of growth to move to acquire smaller companies that are growing at a brisk pace.
