Whether you're a relatively new investor or have been putting your money to work for many decades, what you've witnessed over the past five weeks is unlike anything anyone has ever seen before.
The spread of COVID-19 has pushed equities into bear market territory faster than any previous correction. This steep decline has also included the quickest 30% drop for U.S. indexes on record, even surpassing the rapid drop witnessed during the Great Depression. Between the unknowns surrounding this illness and the mitigation measures being put in place to slow its spread, the short-term damage to the U.S. economy will be palpable.
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Thankfully, we've seen bear markets play out before, and the result has always been a happy ending for long-term investors. No matter how steep or prolonged the decline, bull-market rallies always wind up putting bear markets firmly in the rearview mirror over time. This means the coronavirus crash could be the perfect opportunity for investors to go shopping.
In recent weeks, I've highlighted everything from brand-name companies that look attractive to screaming buys and income stocks to buy. But what I've yet to cover are the numerous small-cap bargains that have surfaced as a result of COVID-19. As long as you have the proper long-term mindset, the following three small-cap stocks (defined as having a market capitalization under $2 billion) are worth buying.
Innovative Industrial Properties
Though marijuana stocks haven't exactly performed well over the past year, there are a few exceptions to the rule. At the top of that list is cannabis real estate investment trust Innovative Industrial Properties (IIPR 0.73%).
IIP, as the company is also known, acquires cannabis cultivation and processing sites in the U.S. and leases these assets out for extended periods of time (typically 10 to 20 years). This allows the company to reap the rewards of rental income while generating highly predictable cash flow. Not to mention, IIP passes along rental increases to its tenants every year and tacks on a property management fee that's based on a property's rental rate. So there's a modest organic growth component built into this company that most folks might not know about.
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According to Innovative Industrial Properties, the company owns 53 properties in 15 states, with a weighted-average remaining lease length of 15.9 years and an average return on capital of 13.2%. Or, to put this jumble of data into something that's easier to understand, IIP has invested around $780 million, including reimbursements for property upgrades, and it'll see a complete payback on this aggregate investment in about 5.5 years. With the average remaining lease being close to 16 years, IIP has a long runway of profits ahead of it.
As the icing on the cake, marijuana remains a federally illicit substance in the U.S., and this classification doesn't look as if it'll change anytime soon. This makes Innovative Industrial Properties a go-to source for sale-leaseback agreements. These agreements help to put cash into the pockets of U.S. multistate operators, while IIP is able to continue building its asset portfolio.
Currently paying out a 6% yield, Innovative Industrial Properties is a screaming buy for a small-cap cannabis stock.
American Eagle Outfitters
There's no denying that retail is taking a direct hit from COVID-19, with the vast majority of major apparel retailers closing their doors for at least two weeks. For some brick-and-mortar retailers, this could be the straw that breaks the camel's back. But for others, such as teen- and young-adult-focused retailer American Eagle Outfitters (AEO 4.97%), it's an opportunity to pick up a great company from the clearance rack for a price that hasn't been seen in more than 16 years.
Even though online retailers have been chipping away at the foundation of department stores and many mall-based retailers for years, American Eagle hasn't succumbed to the pressure. On a comparable-store sales basis, American Eagle has delivered 20 consecutive quarters of positive growth, while its intimate apparel brand Aerie has returned 21 straight quarters of double-digit year-on-year comp-sales increases. This was not a struggling company before the coronavirus, and it'll be just fine when the U.S. economy restarts.
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American Eagle Outfitters' management team is another source of success. Unsold inventory is a problem that all retailers eventually contend with. However, this company has never had much of an issue quickly discounting its excess inventory and putting unwanted product into the rearview mirror. At the same time, management continues to actively promote the company's direct-to-consumer sales and has plans to open between 60 and 70 new Aerie locations in 2020. In other words, management deserves a round of applause.
While it's unclear if American Eagle Outfitters will keep paying out what's nearly a 7% dividend, the company pointed out last week that it ended 2019 with $417 million in cash and no debt and recently drew $300 million from a revolving credit facility to bolster its cash on hand. Assuming 2021 is back to business as usual, we're looking at a small-cap company valued at roughly 6 times its per-share profit potential that has a rock-solid balance sheet.
Intercept Pharmaceuticals
Keep in mind that not every company needs to be profitable to be in bargain territory following the coronavirus crash. Savvy biotech investors looking for an incredible growth opportunity might want to consider putting their money to work in Intercept Pharmaceuticals (ICPT).
Shares of Intercept were relatively volatile long before COVID-19. That's because clinical data for leading drug Ocaliva has been a mixed blessing for the past couple of years.
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Ocaliva is currently approved to treat primary biliary cholangitis, an indication that might generate around $300 million in peak annual sales. But the real prize would be a label-expansion opportunity to treat patients with nonalcoholic steatohepatitis (NASH), a liver disease that can lead to fibrosis, cancer, and even death. There is no Food and Drug Administration (FDA) -approved treatment for NASH -- but with between 2% and 5% of U.S. adults affected by the disease, it could easily be a $35 billion indication for approved therapies.
On the plus side, Ocaliva's late-stage studies have shown an outperformance relative to the placebo with regard to lessening liver fibrosis without a worsening of NASH. On the downside, the high (and most effective) dose of Ocaliva in late-stage studies presented with a number of cases of pruritus (itching). This has led to some safety concerns surrounding Ocaliva.
My take is that even with concerns regarding pruritus, Ocaliva will have first-mover advantage and be approved by the FDA by no later than its June PDUFA date. Even if Ocaliva only targets a small subset of NASH patients, it'll have a direct runway to $1 billion or more in annual sales. That would make the $1.9 billion Intercept Pharmaceuticals quite the bargain.
