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The Russell 2000 (^RUT) is packed with potential breakout stocks, thanks to its focus on smaller companies with high growth potential. However, smaller size also means these businesses often lack the resilience and financial flexibility of large-cap firms, making careful selection crucial.

The high-risk, high-reward nature of the Russell 2000 makes stock selection critical, and we’re here to guide you toward the right ones. That said, here are three Russell 2000 stocks to avoid and better alternatives to consider.

Penguin Solutions (PENG)

Market Cap: $929 million

Based in the US, Penguin Solutions (NASDAQ:PENG) is a diversified semiconductor company offering memory, digital, and LED products.

Why Do We Pass on PENG?

1. Sales tumbled by 9.4% annually over the last two years, showing market trends are working against its favor during this cycle

2. Responsiveness to unforeseen market trends is restricted due to its substandard operating profitability

3. Low returns on capital reflect management’s struggle to allocate funds effectively, and its shrinking returns suggest its past profit sources are losing steam

Penguin Solutions’s stock price of $18.10 implies a valuation ratio of 11.3x forward P/E. Check out our free in-depth research report to learn more about why PENG doesn’t pass our bar.

Arlo Technologies (ARLO)

Market Cap: $1.29 billion

Originally spun off from networking equipment maker Netgear in 2018, Arlo Technologies (NYSE:ARLO) provides cloud-based smart security devices and subscription services that help consumers and businesses monitor and protect their homes, properties, and loved ones.

Why Does ARLO Fall Short?

1. Sales trends were unexciting over the last two years as its 3% annual growth was below the typical business services company

2. Smaller revenue base of $505.8 million means it hasn’t achieved the economies of scale that some industry juggernauts enjoy (but also enables it to grow faster if it executes properly)

3. Poor free cash flow margin of 1.6% for the last five years limits its freedom to invest in growth initiatives, execute share buybacks, or pay dividends

At $12.50 per share, Arlo Technologies trades at 19.4x forward P/E. Read our free research report to see why you should think twice about including ARLO in your portfolio, it’s free.

Methode Electronics (MEI)

Market Cap: $253.4 million

Founded in 1946, Methode Electronics (NYSE:MEI) is a global supplier of custom-engineered solutions for Original Equipment Manufacturers (OEMs).

Why Are We Out on MEI?

1. Sales stagnated over the last five years and signal the need for new growth strategies

2. Free cash flow margin dropped by 19.6 percentage points over the last five years, implying the company became more capital intensive as competition picked up

3. Shrinking returns on capital from an already weak position reveal that neither previous nor ongoing investments are yielding the desired results