Is there any sizzle left in small-caps?
With the Russell 2000 index of small-company stocks near a record high, some analysts think the small-cap rally may not have much juice left. Small-caps are trading at a 14% premium to large-cap stocks, based on trailing operating earnings, according to the Leuthold Group, an investment firm in Minneapolis. That's well above the median premium of 2% since 1983. And small-caps look even pricier based on estimated 2012 earnings, trading at a 17% premium to large-caps.
Small but mighty
Yet small-caps could still be a rewarding investment for long-term investors, according to many financial advisers. Wall Street analysts devote far more research coverage to larger companies, leaving small-cap stocks "mispriced" more often, says Jim Holtzman, a financial adviser with Legend Financial Advisors in Pittsburgh.
Companies with market values between $300 million and $2.5 billion are generally considered small-caps. These businesses tend to be in the early stages of their growth cycles and often have low market share, offering more potential for gains. Most small companies have less foreign exposure than large-caps, creating opportunities to grow internationally. And profit margins are usually lower with more room for improvement.
"Small companies are a little riskier, all else being equal, but you get paid to take that risk," says Jay Kaplan, a small-cap fund manager with Royce & Associates, an investment firm in New York.
Historically, small-cap stocks have won the performance race too. From 1927 to 2004, small-caps returned an average of 13.5% a year while large-caps returned 10.5%, according to Kenneth French, a financial markets expert at Dartmouth. The Russell 2000 index of small companies has returned more than 120% in the last decade, roughly double the S&P 500's (.SPX) 64% gain, and small-caps have returned 9.6% in the last five years, versus a 0.2% gain for the S&P.
Granted, small- and large-cap stocks are like long-distance cyclists, each sprinting ahead at different points in the race. Small-caps are risky assets that tend to fare best when the economy is accelerating and interest rates are rising; large-caps, by contrast, tend to outperform in a declining economic climate. These cycles can last for years. And with smaller stocks now looking a bit pricey, some market analysts think large-caps may outperform for some time.
Yet with corporate revenue and profit growth slowing across the board, small-caps still look relatively healthy. Revenues for large-caps grew 2.8% on average in the second quarter while small-caps reported 6% growth, according to the Leuthold Group. And large-cap earnings rose 2% versus a 7.3% jump for small-caps.
While the smaller end of the equity market looks pricey, some professional investors say they're finding reasonably priced stocks with strong, long-term growth. "I don't need to stretch to find companies with good upside," says Chuck Myers, manager of the Fidelity Small Cap Discovery Fund (FSCRX).
Given the volatility of small-cap stocks, most financial advisers don't recommend trying to pick the best ones. Fund managers can lower the risk by investing in a diverse basket of stocks and digging deep into company financials, and several small-cap funds have beaten their benchmark index over the years with a moderate-risk approach.
To find compelling small-cap funds, we screened for funds with strong three- and five-year records, reasonable expenses and no loads or transaction fees. We looked for growth and value funds, and we ruled out funds with excessive volatility. We also included international funds to add some diversity to the mix. Below are five funds that aced our test:
Fidelity Small Cap Discovery Fund
- 3-year average annual return: 17.2%
- Expense ratio: 1.07%
Chuck Myers caught the investing bug at age 12, buying shares in a closed-end fund that held Australian debt. It wasn't a great trade, but Myers found that he loved researching small companies — largely because the CEOs returned his calls. Indeed, as an undergraduate at the Wharton School, he owned shares in shoe company Steve Madden and called Madden himself one day to arrange a meeting in Long Island.
"I showed up at his office and he said, 'How old are you?' " Myers recalls. "We had a great conversation."
As manager of the Fidelity Small Cap Discovery Fund (FSCRX), Myers still takes deep dives into small companies, though they usually meet him at Fidelity headquarters in Boston. He evaluates companies over an entire economic cycle — not just the next quarter or year — and looks for stocks that trade at low multiples of earnings or cash flow. Out of a universe of 2,000 stocks, only 70 stocks currently make the cut. And Myers holds stocks for years, keeping the portfolio's annual turnover rate around just 20% (which helps to minimize trading costs).
Rather than invest in flashy growth companies, Myers likes "boring" businesses with low expectations and a wide margin of safety. He owns shares in a t-shirt company, for example, that was spun out of a larger corporation; the business is paying down debt, he says, and profitability is improving. Another core holding is a physician's practice management company that has strong financials, operates in a niche area (caring for premature babies) and has a large market share — helping insulate it from competition and protecting it from pricing pressure.
While the fund has fallen sharply in bear markets, it's beaten 90% of peers over the last decade, according to Morningstar, and outperformed the Russell 2000 index by an average of 1.6 percentage points. The fund can always hit a rough patch, of course, and Myers acknowledges "it's incredibly difficult to outperform the index." Still, he thinks small-caps bought at reasonable prices offer good long-term growth. Plus, "it's more fun than large-cap investing."
Intrepid Small Cap Fund
- 3-year average annual return: 11.6%
- Expense ratio: 1.46%
Jayme Wiggins gets a kick out of seeing wrestlers like The Miz do his "Skull-Crushing Finale" move. But World Wrestling Entertainment's stock is what really gets him pumped. Wiggins' fund is the largest shareholder in WWE (WWE) outside the McMahon family. The company has reported lower earnings as it attempts to launch its own TV network. But Wiggins thinks earnings are "temporarily depressed" and that the stock will rebound as earnings recover. It also yields 5.5% — an attractive income stream in today's market.
WWE is one of 36 stocks in the Intrepid Small Cap Fund (ICMAX) — all of which meet strict valuation criteria. The fund's managers evaluate stocks based on their discounts to "intrinsic value," which factors in a company's debt, and they only buy stocks with at least a 20% "margin of safety," based on their estimates of the company's value. In today's market, "it's tough to find discounts," says Wiggins. "Our bottom line is that we won't buy overvalued stocks."
Indeed, if Wiggins and his team can't find enough bargains in the market they'll sit on the sidelines in cash. The approach hasn't always panned out; the fund trailed the market in 2010 and it's lagging again this year with only 67% of its assets invested in stocks. Nonetheless, the fund has managed to preserve capital, making the climb up from a bear market trough much easier. The fund fell just 7.1% in 2008 while the market plunged 37%, and the fund has beaten 99% of peers over the last five years, according to Morningstar, with a 12.8% annualized return.
One area that Wiggins likes now is companies tied to U.S. natural gas production: stocks such as Bill Barrett (BBG), Newfield Exploration (NFX) and Patterson-UTI Energy (PTEN). These stocks have slumped as natural gas prices have fallen in recent years. But they all receive a significant amount of revenue from oil production as well, and are more "balanced businesses" than many investors perceive them to be, says Wiggins.
Holding plenty of cash, meanwhile, gives the fund dry powder to take advantage of a market sell-off. "I recognize our stocks could fall," he says. "If that happens, we'll just buy more."
Janus Triton Fund
- 3-year average annual return: 17.8%
- Expense ratio: 0.94%
When Chad Meade and Brian Schaub think of stocks they'd like to own, an animal comes to mind: the honey badger. A weasel-like mammal that roams Africa and Southeast Asia, the honey badger is a fierce predator with nearly impenetrable skin. It can fend off attacks from jackals and eat a king cobra — after the snake bites first. And it's a wily creature, seeking out honey in beehives (hence the name) or standing on a log to snatch a bird in its claws.
Companies with similar characteristics often make for good investments, says Meade, co-manager of the Janus Triton Fund (JATTX).
Indeed, he and Schaub look for small- to mid-size growth companies that can ride out a downturn and emerge stronger when it ends. They like businesses with thick skins: strong competitive advantages, balance sheet strength and recurring revenues — all of which can help fend off attacks from larger competitors. And they gravitate to companies that control their own destiny, thriving in a niche industry even in a tough economic climate.
With its focus on higher market-caps and "quality" businesses, the fund tends to lag when smaller, more volatile stocks lead the market. That's been the case this year with the fund trailing its benchmark index. Longer term it has fared better, returning an annualized 7.7% in the last five years, and beating 99% of peers in the small-growth category, according to Morningstar.
Lately, the managers have added some "growthier" stocks to the fund. With investors worried about a slowdown in China and Europe, many high-quality companies have been "unfairly punished," says Meade. For example, they recently added a mining equipment and services company that has seen sales weaken but remains highly profitable.
Another company he likes is shoe manufacturer Wolverine Worldwide (WWW), which owns brands such as Merrell, Sebago and Chaco. The company recently bought a rival, adding more brands to its lineup, and is likely to improve profit margins and international sales, says Meade.
A slowdown in the global economy would hurt these stocks, of course. And the managers make no attempt to position the fund according to economic trends. Rather, they figure that profitable companies with wide competitive moats will eventually prevail. "On a multi-year basis we feel good about our stocks," says Meade.
Royce Dividend Value Fund
- 3-year average annual return: 13.7%
- Expense ratio: 1.5%
Investors often overlook dividends in small-caps, figuring that budding companies need to plow all the cash they generate back into the business. But more than 1,100 small companies pay dividends and 770 yielded at least 2% at the end of the first quarter, according to data from Capital IQ Compustat. Moreover, dividend-paying small-caps beat the Russell 2000 index from 1993 to 2011, outperforming in 11 of 19 calendar years.
One top-performing fund: Royce Dividend Value Fund (RYDVX). The fund has beaten 92% of small-blend funds over the last five years, according to Morningstar. The portfolio yields 2.5% versus 1.5% for the Russell 2000 index, and it generally captures more of the market's upside than downside.
"Many people think that small-cap investing has to be sexy, high-growth companies," says co-manager Jay Kaplan. "But there are plenty of somewhat mature but still-growing companies that generate free cash flow and pay some of it back to shareholders as dividends."
Investors have bid up high-yielding stocks such as REITs and utilities, making them less compelling, says Kaplan. "We're about total returns," he adds. "Dividends are only part of it." Kaplan looks for companies with established track records, relatively low valuations and high returns on capital. That eliminates most of the fastest-growing companies on the market; the fund focuses instead on more mature businesses, concentrating on financial, industrial and consumer-discretionary companies.
One top holding: Reinsurance Group of America (RGA). The company reinsures life insurers, and it's highly profitable and predictable, says Kaplan. Another stock he likes is Helmerich & Payne (HP), a contract driller of oil and gas in the U.S. The company has invested heavily in rigs and can drill more efficiently than competitors, enabling it to take market share, says Kaplan.
One caveat with this fund is that its value style is likely to be out of favor in markets that reward riskier stocks. The fund is trailing the Russell 2000 this year and has underperformed over the last 12 months. Kaplan isn't fazed, though: "I try to buy good businesses even if they're hated by the market. In a few years, they won't be hated."
Westcore International Small-Cap Fund
- 3-year average annual return: 15.8%
- Expense ratio: 1.66%
More than 2,500 stocks with a market-cap under $3 billion trade on foreign markets, yet most remain a mystery to U.S. investors — even the pros. Fewer than 100 U.S. mutual funds focus on foreign small-caps and a tiny fraction of these companies are covered by major brokerage firms. "It's not unusual for a company to say we're the first U.S. investors to meet with them," says Jeremy Duhon, co-manager of the Westcore International Small-Cap Fund (WTIFX), based in Denver.
Duhon and his team rack up airline miles to check out these under-the-radar companies. Before packing their passports, though, they look for companies that meet strict criteria for profitability and valuation, and they eliminate companies with inconsistent track records and high economic sensitivity.
The result is a collection of 37 stocks that Duhon says are "the most attractive companies in our stock universe, regardless of sector or country." Indeed, the fund bears scant resemblance to its benchmark, the MSCI EAFE Small-Cap Index: About 40% of the portfolio is in industrial stocks, compared to 22% for the index, and the fund is significantly underweight in Europe and overweight in Asia, excluding Japan.
One top holding, for example, is Cardno (COLDF), an Australian engineering consultancy that's well-diversified across countries and is growing as global standards rise for environmental and safety regulations. Another core holding is Wirecard (WRCDF), a German company that focuses on payment processing in e-commerce; the global e-commerce market is expanding and the company's technology is generating strong growth, says Duhon.
While the fund focuses on high-quality companies, it's not immune to market forces. The fund plunged nearly 49% in 2008, trailing its benchmark index. It beat the market by 17.4 percentage points in 2009, however, returning 64.2%. And it has captured more of the market's upside than downside over the last three years, according to Morningstar, making it a top performer in the foreign small-stock arena.
Daren Fonda is Senior Writer and Investing Columnist with Fidelity Interactive Content Services, a provider of objective investing content on Fidelity.com. He does not own any of the securities mentioned in this article.