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Top 2 Small Cap Automotive Stocks Set for a Strong Rally

The market does not consider automotive stocks the most attractive today, which is precisely why investors should start looking at them. However, not all automotive stocks are equal since the most significant opportunities are arguably found in the small capitalization group today. For reasons that will become clear shortly, one of Wall Street’s legends has also taken this view.

All investors need to know is that stocks like Monro Inc. (NASDAQ: MNRO) and Fox Factory Holding Corp. (NASDAQ: FOXF) are definite standouts within this filtering criteria. Often, these stocks are underrated by Wall Street analysts since their smaller sizes don’t cater to some of the rating houses’ typical clients with billions in buying power, making them low-hanging fruit for retail investors to pick up.

Despite this tendency to ignore small caps, some on Wall Street chose to look inside these companies. Their conclusion? It’s good news for investors with reasonable liquidity and a hunger to make sense of today’s stock market, which isn’t following common logic that much.

Why Now is the Perfect Time to Buy Small Cap Stocks

The short answer is they’re cheap. Compared to the broader S&P 500, the Russell 2000 index has underperformed by over 20% in the past 12 months. Still, that trend could be about to turn on its head relatively soon.

Stanley Druckenmiller – the guy who traded shoulder to shoulder with George Soros – looked into small caps not because there’s no other opportunity in the market but because they may be the best. He recently sold out of Nvidia Co. (NASDAQ: NVDA) and bought into the iShares Russell 2000 ETF (NYSEARCA: IWM) to express his view.

So, small caps are cheap, but why not buy them? Historically, the small caps group has outperformed the rest of the market when the Federal Reserve (the Fed) cuts interest rates, and that is arguably the biggest hope hanging over the market’s head.

Because the CME’s FedWatch tool expects these cuts to come by September 2024, investors now have a reasonable timeline to start potentially accumulating some high-quality – and cheap – small caps.

Monro Stock: Your Inflation Hedge Backed by Analysts

There is a benefit to a slowing GDP environment, as U.S. GDP growth was revised down to only 1.3% for the past quarter. Slowing economic activity typically means cheaper oil and the price per barrel is now struggling to break above $80. Here’s how that helps Monro.

Tires need oil inputs to be manufactured, and as the raw material is made cheaper, Monro’s margins see a massive tailwind. The company’s financials showcase this through a 35.4% gross margin and a healthy enough free cash flow (operating cash flow minus capital expenditures).

Over the past five years, free cash flow stands at roughly $130.9 million. Considering Monro’s $705 million market capitalization, the company trades at only 5.4x price to free cash flow, an attractive discount, to say the least. But is there any upside from here?

Those at Wells Fargo & Co. think there is about a 47.7% upside from today’s stock price. But even if the Fed takes longer to cut rates and kickstart a rally in small caps, Monro’s profitability enables management to pay shareholders an annual dividend yield of 4.7% today, roughly 1% above inflation, to reward investors for their time.

The Impact of Rate Cuts on Recreational Vehicle Demand and Fox Stock Growth

A more direct way to play this potential rate cut thesis is through recreational vehicles. When financing rates are lower, and products like motorcycles, jet skis, and dune buggies become more accessible, Fox stock could stand in the eye of the storm.

Even though the company trades at a more ‘expensive’ price to free cash flow multiple of 18.6x (taking five-year average free cash flow), this financial metric has grown by a compounded average growth rate (CAGR) of 51.8%.

Because of this steadily growing profitability, driven by Fox stock’s gross margin rate of 32%, Wall Street analysts see the company’s earnings per share (EPS) growing by as much as 48.3% in the next 12 months.

These expectations also drove Truist Financial analysts to value Fox stock at $55 a share, daring it to rally by as much as 18.3% from its current price.

All of this evidence helped the Vanguard Group, Fox stock’s largest shareholder, justify boosting its stake by 1.1% in the past quarter, bringing its net investment in the company up to $286.3 million today.

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