Time for Small Companies to Shine

The environment is right for investing in small companies. These five managers divide and conquer the small-cap market.

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Now is proving to be a “super-exciting time to be investing in small companies,” says Shadman Riaz, a comanager of Fidelity Stock Selector Small Cap (symbol FDSCX (opens in new tab)). A growing economy and higher interest rates make a good environment for small-capitalization stocks. What’s more, a rush of initial public offerings means there are more under-the-radar companies on the market—and thanks in part to the popularity of indexing, fewer analysts who research them, says Riaz. All told, “there’s an opportunity for active managers to outperform,” he says.

Stock Selector Small Cap has a unique setup. Five managers run the fund, but the portfolio is divided into three different sleeves, managed separately. Two parts hold a diversified mix of stocks across many sectors. One of those favors growing, high-quality firms; the other tilts toward so-called cyclical, or economy-sensitive, value-oriented opportunities. The third sleeve focuses only on health care stocks.

The managers collaborate, but they don’t work by consensus. “We make individual decisions,” says Riaz. However, they all look for businesses with a compet­itive edge, run by smart executives, that trade at a discount to the managers’ estimate of fair value.

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Table giving stats regarding small-company blend funds

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No matter where they fit in the overall portfolio, stocks in the fund typically meet one of three sets of criteria. Some companies are steady businesses with strong competitive niches, pristine balance sheets and reasonable valuations. Business services provider ExlService Holdings is “growing at a good clip and has good cash flow,” says Riaz. Others are innovative companies with in-demand products. SiTime, for example, makes timing devices embedded in gadgets such as earbuds and smartphones to help them sync quickly. The third group includes out-of-favor cyclicals. Oil refinery HollyFrontier, for instance, has been trading at a low price relative to book value (assets minus liabilities), says Riaz.

The portfolio structure has delivered good results. Over the past three years, the fund’s 18.6% annualized return outpaced 97% of its small-blend peers (funds that invest in small companies with either a growth or value tilt).

Table with stats on 20 largest stock and bond mutual funds

Nellie S. Huang
Senior Associate Editor, Kiplinger's Personal Finance

Nellie joined Kiplinger in August 2011 after a seven-year stint in Hong Kong. There, she worked for the Wall Street Journal Asia, where as lifestyle editor, she launched and edited Scene Asia, an online guide to food, wine, entertainment and the arts in Asia. Prior to that, she was an editor at Weekend Journal, the Friday lifestyle section of the Wall Street Journal Asia. Kiplinger isn't Nellie's first foray into personal finance: She has also worked at SmartMoney (rising from fact-checker to senior writer), and she was a senior editor at Money.