It's been a heck of a run for small-cap stocks. The Russell 2000 Index has risen roughly 80% in just two years and a number of individual stocks have doubled, tripled or even quadrupled. The move is understandable; Small stocks were so badly beaten-up during the downturn that a rebound seemed inevitable.
But now it's time to shift gears. The average stock in the Russell 2000 now trades for roughly 21 times trailing earnings and more than two times book value. Both of these metrics are roughly 20% above the historical norm. More importantly, key themes expected to play out in the U.S. economy are estimated to benefit larger rather than smaller companies. First, the weak dollar is likely to boost the prospects of large cap companies with a high degree of international exposure. Second, consumer spending may finally move up as employment trends strengthen.
Most major retailer stocks are mid and large caps residing in the S&P 500. And that's where I'm setting my sights for 2012: the S&P 500, which has also had a strong run but still has its share of laggards. Four companies in particular have largely missed out on the strong bull market but look poised to catch up in the next few months. I see at least 50% upside potential for each stock.
1. Citigroup (NYSE: C)
Bank stocks remain out of favor. With the housing market still quite weak and lending activity accordingly slow, there are good reasons for caution. As I noted a few weeks ago, many bank stocks can be obtained for right around book value.
The dim sector view is obscuring a brighter picture for Citigroup. With each passing quarter, it's becoming more apparent that this is really a play on international economic activity -- especially in places such as China, Brazil and India -- and less of a play on the moribund U.S. economy.
Right now, quarterly results are mixed, as strong international results offset tepid domestic results. Yet profits are building, which is pumping up book value. Merrill Lynch believes that Citigroup's book value will hit $6.21 by the end of this year, more than 30% higher than the current share price. By the end of 2012, book value could approach $6.75 if current trends continue. Assuming investors finally warm to the stock later this year and set their targets on that end-of-2012 book value forecast, shares look to have 50% upside.
2. Best Buy (NYSE: BBY)
Conventional wisdom says that this major consumer-electronics retailer is in disarray, steadily losing market share to aggressive players such as Wal-Mart Stores Inc. (NYSE: WMT). The fact that sales are expected to rise just 3% this year gives little reason for optimism. Yet if you dig deeper, then you'll see a company suffering from internal missteps and a still-weak consumer economy -- not one that has lost its competitive edge.
To be sure, Best Buy's move of placing a big promotional emphasis on 3-D TVs now looks misguided. Consumers simply didn't want them, and that's the nature of electronics retailing -- there are hits and misses.
But management appeared chastened at a mid-April management meeting as it laid out a game plan that looks more sound. In coming quarters, Best Buy will place an even greater emphasis on mobile devices such as tablets and smartphones, while also helping consumers navigate the "connected home." That's a fancy way of describing the next wave of consumer electronics from TVs to radios to car stereos set for release in coming quarters that will have Internet connectivity at its core. This level of actual "interaction" with products is something rivals such as Wal-Mart and Amazon.com (Nasdaq: AMZN) simply can't replicate. In addition, Best Buy is boosting its efforts in the area of new and used video games and is ramping up its presence in China.
These initiatives, coupled with the fact that employment trends should continue to strengthen, has me convinced that expectations for the mere 2% sales growth in calendar 2012 (fiscal 2013) are far too low. Whereas the analyst consensus sees per-share profits of about $3.67, I see them rising to $4. Shares currently trade for less than seven times this admittedly bullish view. If that multiple expanded to 12, which is not unreasonable, you'd be looking at 50% upside.
3. GM (NYSE: GM)
My colleagues and I have written about the disappointing post-IPO performance of GM. Rising fuel prices clearly bear some of the blame, but it didn't help that management has decided to sharply boost engineering spending in 2011 to have a fresher product line down the road. Unless tensions in Egypt and Libya spread to Saudi Arabia, the risk premium could eventually come out of the oil market, helping prices to ease down toward the $90-a-barrel mark. As oil prices cool, GM's shares could get a solid lift. [Here are other reasons this is a good long-term stock to own.]
Analysts at UBS spot another catalyst: "Given its size, we believe GM will be the biggest beneficiary of the upcoming Japan-related inventory shortages, with the potential to gain of as much as 110 basis points of additional (market) share in 2011. We expect these gains can boost 2011 EBIT by $1billion and EPS [earnings per share] by $0.60/share."
Yet it's the product line that will serve as the main catalyst for this stock. GM's entire car line is in the midst of a revamp, with a big focus on quality and fuel efficiency. Steadily rising market share, coupled with ongoing increases in industry volume, should help GM to operate its factories closer to full capacity and push up margins. As that happens, analysts look for EPS to hit $5 in 2012 and perhaps $6 in 2013. I'm betting investors will begin to focus on that 2013 outlook later this year. Slap a price-to-earnings (P/E) ratio of just eight on that 2013 outlook, and shares would rise to $48, or 50% above current levels.
4. Akamai Technologies (Nasdaq: AKAM)
The bloom is off the rose for this former tech highflyer. Shares have fallen nearly 40% since December and are now touching 52-week lows. Investors have grown concerned that tough competition in the company's core business of providing content delivery networks (CDNs) is leading to steady price erosion. That's surely the case, as it has been for a number of years.
Yet investors are missing the bigger picture. Akamai is also rolling out a wide range of ancillary products and services that are just now being tested and deployed by customers. These new offerings carry far higher profit margins than the commoditized CDN business.
Right now, analysts think profits will rise in the low double-digits in 2011 and again in 2012. Yet that view assumes a significant shrinkage in profit margins as further CDN price cuts take hold. But the new offerings hold the promise of sustaining and even boosting margins. If that happens, then profit growth will be in the upper teens, not the lower teens.
In recent weeks, management has cleared the decks and set a very low bar. Once investors see that future results will be above the currently pessimistic view, then the profit multiple could expand again and push shares back up toward the 52-week high of $54, more than 50% above current levels.
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