Small-company stocks are often the canaries in the market’s coal mine. Typically defined as stocks with a market value of less than $10 billion, their prices usually peak and then decline before large-company stock prices do in anticipation of a top in the economic cycle or a rise in interest rates. Similarly, “they tend to outperform early, when it seems like the worst is behind us,” says Sam Stovall, chief investment strategist at CFRA Research.
Lately, the canaries have been quite chirpy. Over the past six months, the Russell 2000, an index of small-cap stocks, gained a robust 9.1%. It led the S&P 500 index for part of that stretch, a good sign, given that the Russell has lagged the big-company benchmark in seven of the past 10 calendar years. (Returns and data are through March 31, unless otherwise noted.)
No one knows, of course, whether that trend will continue. Uncertainty reigns about when the Federal Reserve will pause its cycle of interest rate hikes and what kind of recession, if any, the economy may experience. But you have plenty of other reasons to give small-company stocks a look now.
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For starters, they’re cheaper than they’ve been in decades. Compared with the S&P 500, the S&P SmallCap 600 index currently trades at a 36% discount, in terms of price-earnings multiples based on estimated earnings for the year ahead. That P/E is also a 22% discount to small caps’ average P/E since 2005. Large caps, by contrast, trade at a 16% premium to their average P/E since 2005.
Analysts have a brighter outlook for small-cap earnings growth than for the rest of the market, too. Although small- company stocks’ earnings growth is “due to underwhelm” this year, says Stovall, it is forecast to exceed that of large-size firms next year. Analysts expect small companies’ earnings to climb by 19% in 2024; mid caps’ earnings should rise by 14%. Large-company stocks’ earnings growth is likely to trail in 2024, with a predicted jump of 12.5%.
And a wobbly economy means now is a prime time to buy stakes in small companies, say some experts. History shows that small-cap stocks rally before an economic rebound is clearly under way. Thus, the current uncertain economic environment makes for a “highly opportune time” to invest in small caps for the long run, according to a recent report from the small-company stock specialists at investment firm Royce & Associates.
Focus on quality
High-quality stocks — firms that generate steady cash flow and boast a clean balance sheet and rising earnings, for instance — can provide some resilience in a rocky market. Says Sebastien Page, head of T. Rowe Price’s asset allocation steering committee: “There are opportunities in small caps, if you look at the quality segment, to lean in and play offense.”
Buying shares in individual stocks is one way to go. But there are caveats: Small-company stocks tend to be more volatile than large stocks. A diversified portfolio of hundreds of small-cap stocks can smooth out the ride some, but that’s hard to build on your own.
With that in mind, we found seven funds with a quality tilt that make it easy to boost your exposure to small-company stocks. Though stock prices may get worse this year before they get better, “they can turn around quickly, too,” says Phillip Cook, a comanager of SouthernSun Small Cap fund. “If you don’t get your ducks in a row now, you won’t benefit.”
Avantis U.S. Small Cap Value ETF. Only highly profitable small companies trading at a bargain price are considered for this low- cost, actively managed exchange-traded fund, run by four managers. Profitability and a low price, says chief investment officer Philip McInnis, are “good proxies” for expected return rates. “If a company is cheap with high profits,” adds comanager Mitchell Firestein, “it’s going to generate a higher expected return.”
Ryder System, best known for rental trucks, sits at the top of the portfolio, which means the managers consider it the most attractive stock based on the fund’s two main criteria: a low price-to-book-value ratio and solid profitability. (Book value is assets minus liabilities.) “I think about the ideal stock the way Warren Buffett does,” says Firestein. “We want to buy wonderful companies at fair prices, not fair companies at wonderful prices.”
The process has delivered solid results since the ETF launched in September 2019, returning 13.6% annualized. That walloped the two major small-company benchmarks, the S&P SmallCap 600 and the Russell 2000.
Dimensional U.S. Small Cap Value ETF. At Dimensional Fund Advisors, the investment firm better known for its DFA mutual funds, any company in the bottom 10% of the U.S. stock market is considered small. Within that universe, the managers ferret out the firms that are profitable and that trade at a low price-to-book-value ratio — a “fairly sticky measure that moves, but gradually,” says Joe Hohn, a senior portfolio manager. That’s in contrast he says, to P/Es, which can be volatile.
The process yields a portfolio of 900-odd stocks, with no single stock accounting for more than 1% of assets. “Diversification is the only free lunch you’ve got” in the investing world, says Hohn, and a portfolio of hundreds of stocks shields the fund from some risk. Dimensional funds are often considered “index-enhanced” funds but, Hohn says, “we are active managers.”
The low-cost ETF has a short track record — it just celebrated its one-year anniversary. Over that period, its 9.0% return beat 92% of its peers (funds that invest in small-company stocks trading at a value). But the ETF uses the same strategy as the decades-old mutual fund DFA U.S. Small Cap Value, available only through certain advisers. Over the past 10 years, the mutual fund’s 8.5% annualized return ranks among the top 27% of its peers. Though short-term returns may vary between the mutual fund and the ETF, over the long term, Hohn says, the two funds should have similar results.
iShares Core S&P Small-Cap ETF. This fund, a member of our Kiplinger ETF 20 list of favorite ETFs (and our favorite small- cap ETF), tracks the S&P SmallCap 600 index. That’s our preferred benchmark of small-company stocks, too, in part because it skews toward higher-quality firms — companies must have posted profits for at least the past 12 months to be considered for inclusion in the index. The Russell 2000 does not have any earnings criteria (only size matters), and that, in part, hurt its performance in 2022. The SmallCap 600’s profit tilt may have made a difference over the long haul, too. Over the past decade, the ETF’s 9.8% annualized return beat the Russell 2000 by an average of 1.8 percentage points per year. The fund’s low, 0.06% expense ratio is a draw, too.
Mesirow Small Company. At Mesirow, profits matter — or profitability expected within the next 12 to 18 months. Price matters, too. Plus, prospective stocks must have catalysts to power earnings and cash flow growth over the next year or so. “We marry those considerations with top-down trends and themes,” such as the growing popularity of electric vehicles, says Leo Harmon, co-lead manager of the fund with Kathryn Vorisek and two comanagers. The combination of a promising stock and a favorable trend is like finding “a good house in a good neighborhood,” he says.
Fund holdings include Gentherm, which makes climate-control systems for cars and electric vehicles (think heated seats and the like). Another favorite, Astec Industries, designs and makes equipment and components for road building and will benefit from the Bipartisan Infrastructure Law enacted in 2021.
Though Mesirow, a Chicago-based investment firm, has been around for decades, the fund is just four years old. Its 25.7% three-year annualized return beat 90% of its peers (small blend funds, which hold stocks with a mix of growth and value traits). Prior to managing this fund, Vorisek and Harmon ran small-cap strategies at Fiduciary Management Associates, a fund firm that Mesirow acquired in 2016.
Oberweis Micro-Cap and Oberweis Small-Cap Opportunities. These growth funds debuted in the mid 1990s but shifted strategy in 2015, when Kenneth Farsalas became lead manager. He ditched the funds’ focus on stocks with fast-growing sales and earnings to concentrate on a behavioral finance quirk called post-earnings announcement drift, he says. “Investors tend to underreact to earnings surprises, specifically when those surprises are caused by big changes in the company.”
Farsalas, along with two analysts and two traders, exploits the trend by closing in on firms that have reported earnings that beat analysts’ expectations and buys stakes only in those with a solid catalyst to propel earnings further — a new product, new executives shaking things up, or new regulations that favor its business. Their interest is piqued “if there’s a positive fundamental change and we think the business is cheap” based on a variety of price multiples relative to the firm’s history and to competitors, he says. But if the surprise was driven by a lower tax rate, say, or a one-time sale of an asset, they generally pass.
A current favorite in the Small-Cap Opportunities fund is semiconductor-equipment company Aehr Test Systems. Farsalas says its sector is poised to turn around. The firm makes systems used to test newly manufactured semiconductors and will be “a direct beneficiary of the electric-vehicle boom,” he says, because it is the leader in testing silicon carbide chips for EVs.
The funds’ investment approach results in what Farsalas calls “aggressive” portfolios. Volatility is above average at both funds, but so are the long-term results. Micro-Cap has returned 16.9% annualized since Farsalas took over. It tends to be even more volatile than its small-cap fund sibling, so keep any exposure to a small percentage of your total stock holdings. Small-Cap Opportunities has gained 13.7% annualized since Farsalas took over. The S&P SmallCap 600 index rose 8.3% annualized over the same period; the Russell 2000, 6.4%.
Farsalas says his focus on profits helped both funds hold up better than the Russell 2000 index in 2022 because the fund doesn’t hold shares in non-earning firms, such as burgeoning biotech companies. It avoids real estate investment trusts and utilities, too. “It’s an urban legend that small- and micro-cap companies aren’t high quality. Plenty of small- and micro-cap companies have real earnings, generate real cash flow and have good balance sheets,” he says.
Pacer U.S. Small Cap Cash Cows 100 ETF. This fund’s objective is to invest in the most-profitable small companies. To do so, it holds the 100 firms in the S&P SmallCap 600 index with the highest free-cash-flow yield — the ratio of free cash flow (cash left after expenses and investments to run or expand the business) to a firm’s enterprise value (basically, the price you’d pay to buy the company today, taking into account its cash on hand and debt). The index-based ETF is rebalanced quarterly.
A focus on free-cash-flow yield, as opposed to the price-to-book-value ratio (a traditional value measure), allows the fund to include firms that are low on real assets but loaded with intangible assets — ones you “can’t see, touch, feel or put a price tag on,” such as health care companies with drug patents, says Sean O’Hara, president of Pacer ETFs Distributors.
The ETF didn’t have a great 2022; it lagged 88% of its peers (small value funds). But its three- and five-year records are smashing, and since the start of 2023, it has outpaced 94% of similar funds, with a 6.5% return. Top holdings include Encore Wire, a maker of electrical building wire and cable, and Asbury Automotive Group, a car-dealership company.
Note: This item first appeared in Kiplinger's Personal Finance Magazine, a monthly, trustworthy source of advice and guidance. Subscribe to help you make more money and keep more of the money you make here.
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