4 Small-Cap Stocks to Consider Amid the Downturn

That seems extreme—and it could be an opportunity for investors willing to search for baby banks thrown out with the bathwater. There are plenty of targets—many of the more than 200 bank stocks in the Russell have declined by double digits in recent weeks. The question is, which ones to buy?

Phillip Cook, co-chief investment officer at SouthernSun Asset Management, points to
Live Oak Bancshares
(ticker: LOB). Shares of the Wilmington, N.C.–based institution have lost about a quarter of their value this month, even though it is a very different animal from the regional banks that are facing issues. Live Oak, which had $9.9 billion in assets at the end of 2022, is focused on lending to small businesses, and many of its loans are guaranteed by the federal government, which means lower risk of losses due to defaults.

Cook sees the bank gaining market share in a potential recession as other lenders pull back from small-business lending. Some 42% of Live Oak’s loan book is government-backed, versus 3% for the U.S. banking industry overall.

Investors don’t have to stick with traditional banks to find opportunities. Pullen Investment Management’s Tyler Pullen points to trading firm and market maker
Virtu
Financial (VIRT), which benefits from increased market volatility. The company has been under fire lately by the Securities and Exchange Commission, which has proposed regulations targeting payment-for-order-flow practices.

That has caused Virtu’s stock to drop 13% this year and to diverge from a rising VIX—which it usually tracks closely, per Pullen. He expects the financial impact on Virtu of potential SEC regulation to be manageable and for market volatility to remain elevated in 2023, as is typical around shifts in Fed policy and recessions.

Pullen also likes
Federal Agricultural Mortgage
(AGM), colloquially known as Farmer Mac. It’s a government-sponsored enterprise akin to
Fannie Mae
or
Freddie Mac
: It purchases agriculture-related loans from banks and other lenders, securitizes them, and sells them to other investors. The stock has been caught up in the banking selloff and is down 15% in two weeks. Pullen sees Farmer Mac solving a real need for farmers that’s government-backed, has solid organic loan growth, and isn’t tied to Silicon Valley, home mortgages, or consumer credit.

“Credit events in this space are few and far between, and the farm collateral is a good asset,” he says.

Even nonfinancial small-caps have gotten hit hard. SouthernSun’s Cook calls out
Darling Ingredients
(DAR), which has the unglamorous business of taking the meat processing industry’s leftovers and rendering them into proteins and fats that can be put to use elsewhere.

Growing demand for sustainable fuels has been a tailwind for Darling, which converts some of the leftovers into renewable diesel and aviation fuel. It also makes raw materials for animal feed and human consumption, such as collagen supplements.

Darling stock, though, has been dragged down more than 20% this month due to the drop in oil and other commodities prices. But the company isn’t selling gasoline—the demand for its fuels is driven more by regulations and environmental considerations than economic activity, says Cook.

Darling stock appears to have been thrown in the garbage by a market that isn’t paying much attention to fundamentals. It’s a ripe time to fish for bargains.

Write to Nicholas Jasinski at nicholas.jasinski@barrons.com