Better times for small-company stocks might be on the way—and active managers are already having a remarkably good year.
Smaller companies usually get hit harder in recessions: Their revenues are more economically sensitive, and they tend to have less cash for crises. This year bore that out, as the pandemic shut down many economic activities. Companies in the S&P SmallCap 600 index (.CVK) saw third-quarter earnings sink 72% from the year-earlier level, compared to S&P 500’s (.SPX) 19%.
But as the U.S. opens, things are looking up. Unemployment has declined, and business activity has been recovering. Small-cap stocks have historically performed well coming out of recessions and off market lows. Since the end of June, analysts have forecasted small-company earnings for 2021 to grow by more than 30 percentage points over what they previously expected; large-cap estimates have increased only two points. Small-cap earnings should rebound sharply in 2021 to more than 10% above 2019 levels.
Investors can have a low-cost, broad exposure to small-caps via exchange-traded funds tracking the Russell 2000 or S&P SmallCap 600 index. This year, growth names have been favored over value. While value stocks in the Russell 2000 (.RUT) are down 18% for the year, their growth peers have bounced back to record highs—their 9% gains even beat the S&P 500. The $9.2 billion iShares Russell 2000 Growth ETF (IWO) has an expense ratio of 0.24%, while the $370 million Vanguard Russell 2000 Growth ETF (VTWG) charges 0.15%.
Yet active funds could be more appealing right now. With the pandemic disrupting old industries and creating new ones, it’s especially important to pick the right names that will emerge as future winners, and avoid those that might lose out.
Small-cap managers have proven that they can do just that, at least for now. More than 60% of nearly 200 active small-cap growth funds tracked by Morningstar have beaten the Russell 2000 Growth index (.RUO) this year, and they’ve outperformed by an average of more than six percentage points. In 2019, the group barely matched the benchmark. Active large-cap growth funds, meanwhile, have eked out a mere one percentage point advantage over the S&P 500 Growth index (.SGX).
Outperforming funds include the $3.2 billion Lord Abbett Developing Growth fund (LAGWX) and the $410 million Alger Small Cap Growth fund (ALSAX). Although the two have less than 15% overlapped holdings, both have returned more than 43% year to date and an annualized 20% over the past five years. This suggests plenty of opportunities for successful stock-picking in the small-cap space.
“A lot of the smaller companies that we invest in have been able to pivot their business and take advantage of the opportunities that came up during the pandemic,” says Jamie Cuellar, portfolio manager of the $738 million Buffalo Small Cap fund (BUFSX). “They can move quicker, relative to the large-caps that try to do the same.”
Cuellar particularly likes telecom stocks, due to the advent of 5G technology and higher demand for internet bandwidth. Tensions between the U.S. and China have also given domestic suppliers the chance to expand abroad, as Huawei—a major global rival—is being excluded from many international markets.
Diagnostics also has great potential, says Cuellar. Even though many of the companies aren’t making money, profitability can improve dramatically in the coming years, with a huge addressable market. The Buffalo fund has returned 34% this year. Top holdings include genetic-testing company Natera (NTRA) and furniture retailer Lovesac (LOVE).
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