The start of the year looked great for stocks of smaller companies as they led the market’s January rally after a brutal 2022. What no one saw coming is that a regional banking crisis in March would drag down returns of the small-cap index and send jitters throughout the market.
It may be time to buckle up, as small-cap stocks could be poised to take off again.
The near-term outlook for small companies is still bumpy, with lingering worries about the economy, tighter credit conditions, and the health of regional banks. But history tells us that small-cap stocks tend to underperform going into a recession and outperform coming out of one. There’s also the small-cap effect to consider: the tendency of small companies to produce higher average returns than large ones over long time periods.
Jill Carey Hall, head of U.S. small- and mid-cap strategy at Bank of America, says the firm’s economists are calling for a mild recession this year, beginning in the third quarter and lasting till early next year. The market usually bottoms before the economy—about six months before the recession is over—and “small-caps usually bottom around the same time as large-caps and then outperform off the bottom,” she says.
Investors should take the long view when it comes to smaller companies. “There is certainly more potential for some downside risk near term,” says Hall. “But if you do have a longer time horizon and can potentially withstand some further potential downside or volatility, the longer-term multiyear backdrop for small-caps does look attractive.” About 8% of the
Russell 2000
small-cap index is composed of regional banks, compared with 1% for the broader
S&P 500.
While that’s not a big chunk of the index, “if you’re taking a relative position on small versus large-caps, it is significantly larger than the exposure in the large-cap index,” she says.
With so much turmoil in the markets, the coming months could be a time for active managers to shine. “Valuation dispersion is very high, with very cheap and very expensive stocks, and that presents opportunities for fundamental value investors to do stock-picking,” says Hall.
Indeed, some managers are outperforming—and banking on better days for the sector. One of those is Chuck Royce, chairman and portfolio manager at Royce Investment Partners, a unit of Franklin Templeton.
Royce is well known for its longstanding focus on the small-cap sector. Its flagship strategy, the $1.6 billion
Royce Pennsylvania Mutual
fund (ticker: PENNX), has outperformed the Russell 2000 for the one-, three-, five-, 10-, 15-, 20-, 25-, 35-, and 40-year periods ended March 31. For the year through April 30, the fund was up 5.78%, according to Morningstar Direct, handily beating the Russell 2000’s gain of 0.89%.
Royce, who has helmed the fund since its 1972 launch, says his team of managers scours the small-cap universe for businesses that look mispriced and underappreciated. “They must also have a discernible margin of safety” to allow them to withstand challenging periods, he says. That is most commonly found in a strong balance sheet, which should allow a company to not only survive short-term difficulties but also position it to take market share from less conservatively capitalized competitors, he adds.
The fund takes a multidiscipline approach that offers exposure to strategies that have tended to perform well in different market environments, including high quality—companies that have high returns on invested capital, low-debt balance sheets, and are generating free-cash flow—emerging quality, traditional value, and quality value. The fund, which holds nearly 300 stocks, has long favored cyclicals—the most economically sensitive stocks—including industrials and tech stocks.
On the other end of the spectrum, with only 28 stocks in its portfolio, is the Morningstar five-star-rated
Davenport Small Cap Focus
fund (DSCPX), which returned 9.07% through the end of April. The fund, which has nearly $600 million in assets under management, has consistently outperformed, ranking in the top quartile over one, three, and five years. For the five-year period, it outperformed 99% of its category peers, according to Morningstar.
Portfolio co-manager George Smith says the fund focuses on “unique and underfollowed businesses that have idiosyncratic growth drivers.” Its top two holdings are
NewMarket
(NEU), which produces additives for motor fuel, and
Monarch Casino & Resort
(MCRI), which the fund first bought in 2015. NewMarket is up 19% over the past 12 months, at $393.04, while Monarch is up 4.5%, at $67.27.
The fund’s consistent performance, adds co-manager Chris Pearson, is a function not only of the companies it owns, but also those it has avoided. “We have a strict discipline around high-quality businesses that generate substantial amounts of free cash flow and have capable management teams that can reinvest that cash at higher rates of return,” he says. “We do not chase momentum.”
Pearson notes that a high percentage of companies in the Russell 2000 are unprofitable. “We way over-index to profitability,” he says. “Insider ownership is another element of our strategy that we emphasize.” At Monarch, “insiders own north of 20% of the company,” he says. The company has “a rock-solid balance sheet” that allowed it to weather the pandemic.
Write to Lauren Foster at [email protected]
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