Mike’s Note: Welcome to our first-ever True Options Masters Predictions Week! All week long, you’re going to hear what the whole TOM team is banking on for 2022 and beyond.
Amber took a sharp, analytical approach to her prediction for 2022. She knows that rates are likely going up. She knows, like Chad, that small caps are poised to outperform because of this. But she also knows that not all small caps are created equal, and only those of a certain quality will rise to the top. Read on to see what she dug up…
When my editor Mike Merson asked me to make a prediction of what we’ll see in 2022, I thought about the fundamental market picture.
What is the fundamental thing that is changing next year?
It didn’t take me long to find it: It’s finally time for interest rates to rise.
Of course, even if the Federal Reserve follows through on its target of three or four increases next year, short-term rates will still be near multi-millennia lows.
According to records dating back to 3000 B.C., rates have dipped below 2% just once before 2008, in the Great Depression. Nowadays, rates above 2% sound like lunacy.
This tells me that higher rates won’t necessarily be a problem for the stock market, since rates are just returning to normal. But the cause for the higher rates, inflation, could be a worry.
That will impact stocks in 2022, but the effects won’t be uniform. Some companies will benefit from inflation while others will suffer.
High-quality small caps, in my view, should benefit the most in this environment. Problem is, those aren’t exactly easy to find.
So for my contribution to this 2022 predictions series, I don’t want to simply say that high-quality small caps will outperform.
I want to show you how to separate the wheat from the chaff and trade the stocks best positioned to do so…
Next Year’s Small-Cap Winners
I like small caps for 2022 because these are the companies that are nimble enough to navigate the unpredictability that the Fed brings to the markets. But only the highest-quality small caps should be considered.
To define quality, I started by looking for companies with profit margins that are at least 25% better than average. I expect average profit margins to increase next year, and the companies that are already excelling by this measure are the ones that should drive that expansion.
To ensure the profits came from operations rather than accountants, I required a positive cash flow from operations. In the long run, a company needs to generate profits from operations rather than from accounting credits. This is an important filter that many analysts ignore.
To ensure the company can navigate an inflationary environment, I screened for companies with low debt levels. The specific filter was a debt-to-equity in the lowest 5% of companies in the S&P 600.
(Why the S&P 600 and not the more well-known Russell 2000? Stocks in the former are always more liquid and optionable — essential characteristics for the kind of trades we want to make.)
At the same time, I eliminated companies with no debt. I wanted to ensure the company had access to bond markets and could raise cash quickly if that was necessary.
These filters identified high-quality companies. But we trade stocks, not companies.
So, I finished my search for next year’s winners by looking at stocks that are trading within 15% of their 52-week high. This shows that other traders have found these stocks and have been pushing the prices up.
Without other traders knowing about the stock, we risk sitting on a stock that goes nowhere and that’s not really my goal.
Eight small caps passed my screen.
Cavco Industries, Inc. (CVCO)
American Equity Investment Life Holding Company (AEL)
Badger Meter, Inc. (BMI)
Onto Innovation Inc. (ONTO)
Safety Insurance Group, Inc. (SAFT)
Employers Holdings, Inc. (EIG)
Exponent, Inc. (EXPO)
That’s a starting point for researching the stocks that should be among the biggest winners of 2022. Each of them is optionable. That allows for trading options, which can multiply the potential returns while limiting the downside risks.
Overall, I expect 2022 to be a volatile year. The best strategy may be to trade in and out of stocks like this as trends develop in the broad market.
Senior Analyst, True Options Masters