David Snowball, PhD, publisher of MutualFundObserver.com, an independent mutual fund–analysis website that tracks 36,000 investment products. He also is professor of communications studies at Augustana College, Rock Island, Illinois.
As fast-growing behemoths such as Netflix, Tesla and Meta Platforms (the parent company of Facebook) falter this year, it’s time to start thinking small.
Small-cap value stocks—cheaply valued businesses with market capitalizations under $2 billion—have held up much better this year, falling 13.7% through June 13 versus 21.3% for the S&P 500 index. After being out of favor for most of the past decade, a long-awaited rotation has begun and small-cap value is poised for relatively sustained outperformance in 2022 and beyond. The signs include…
Extreme historical valuation gaps. While large-cap valuations remain inflated, small-cap value stocks now are priced near the bottom of their long-term valuation range. Currently, the S&P 600 SmallCap Value index has a price-to-earnings ratio (P/E)—a common measurement of a stocks’ value—of 12.3 versus 17.7 for the S&P 500.
Growing economy and above-average inflation. Small companies are more sensitive to the strength of demand in the domestic economy than larger ones. Investors often underestimate just how strongly a broad cyclical recovery, such as the one we are having right now, can boost small-cap earnings. Also, rising inflation pushes up interest rates. That makes value stocks look more attractive to investors than growth stocks, whose companies often are heavily leveraged.
If you want stock exposure now and your portfolio has become skewed toward giant companies in recent years, you may be able to improve future returns by diversifying with small-cap value stocks.
To help our readers invest wisely, Bottom Line Personal spoke to investment expert and publisher of MutualFundObserver.com David Snowball, PhD…
Small-cap stocks can be challenging to own—they’re streaky, going in and out of favor for long periods of time—but they can be worth the hassle for patient, long-term investors. From 1970 through 2021, small-cap value stocks have an average annual return of 13.8% versus 11% for the S&P 500. Since small-caps make up about 10% of the US stock market’s total investable market capitalization, that’s a reasonable starting point for determining your own portfolio allocations. What you need to know…
Consider an actively managed fund. Although small-cap value funds can be costly—with expense ratios of 1% or higher—it’s easier for a talented manager to beat his/her benchmark index after expenses than other asset classes. Reason: Small companies receive scant attention from Wall Street analysts, so they are more often mispriced.
Expect higher volatility. Small companies tend to be riskier than larger ones, and they generate a bumpier ride. Over the past decade, small-cap value stocks have been about 50% more volatile than the S&P 500.
Make sure you have exposure to “microcap” value stocks. These are the smallest of the small-caps, with typical market capitalizations under $300 million—that’s about 9,000 times smaller than Apple. Studies show that much of the outperformance of small-cap value stocks over long periods is generated by the robust returns from these tiny publicly traded companies.
The four no-load mutual funds listed here all are rated four or five stars by Morningstar.
The funds for more aggressive investors use bold strategies and are substantially more volatile than the S&P 500, but they offer category-topping long-term returns. The funds for more moderate investors are focused on higher-quality companies and have similar volatility as the S&P 500, so over time you may get better performance without taking on any additional risk.
For more aggressive investors…
Aegis Value Fund (AVALX) is the daredevil of the small-cap-value category. It is a high-wire act that has produced huge ups and downs but also excellent long-term returns. Manager Scott Barbee invests in about 50 “deep-value” stocks—these are fundamentally sound companies with an average market cap of just $400 million. Barbee favors companies that have been beaten down in stock price but that he thinks have undervalued assets or overstated liabilities, as well as the potential to gain 80% to 100% over the next three to four years. The fund heavily overweights sectors with 67% of assets recently in basic materials and another 29% in energy. One downside: The fund’s expense ratio is relatively high at 1.5%. Top holdings: Canadian lumber producer Interfor Corp…copper processor and producer Amerigo Resources. Performance: 13.7%.*
Royce Opportunity Fund (RYPNX) takes a contrarian approach, often picking up firms selling at depressed prices because they have less-than-perfect financials…are emerging from bankruptcy…or are rebounding from management problems. The companies, often in the industrials and technology sectors, need to have viable catalysts for future earnings growth. Last year, the fund underwent a crisis when its managers abruptly jumped to a competitor. Royce Opportunity coaxed the fund’s heralded former manager Buzz Zaino out of semiretirement, and its top-rated performance has continued. Zaino keeps about 60% of the fund’s assets in microcaps but tempers volatility by spreading assets over about 250 companies, and he limits the fund’s top holdings to 1% of its total assets. Top holdings: Aerospace services and components company Triumph Group…steel producer Cleveland-Cliffs. Annual expense ratio: 1.21%. Performance: 12.2%.
For more moderate investors…
Bridgeway Small-Cap Value Fund (BRSVX) returned 68% last year, making it the best-performing diversified stock fund of 2021. But the fund has distinguished itself in a number of other ways as well. It’s a “quant” fund, relying completely on computer programs to dictate its portfolio of 134 mostly microcap stocks and taking the emotion out of the decision-making process. Manager John Montgomery, who began his career as a research engineer at MIT, has designed the proprietary software to evaluate a variety of criteria including price valuations, the financial health of the business and the stock’s price momentum. The fund has very high turnover. It recently kept about half of its assets in financial services, industrials and health care. The fund’s expense ratio adjusts upward or downward each year, based on its performance relative to the Russell 2000 value index over a rolling five-year period. Top holdings: Specialty paper manufacturer Veritiv…regional grocery distributor and retailer SpartanNash. Annual expense ratio: 0.92%. Performance: 13.1%.
FPA Queens Road Small Cap Value Fund (QRSVX) takes a classic, conservative approach, managing as much for safety as for return. It has only about 16% of its portfolio in microcaps, and its overall volatility is lower than that of the S&P 500 index. Manager Steve Scruggs looks for what he calls “quality value,” established companies with strong balance sheets and cash flow and little or no debt and that are trading inexpensively. Scruggs owns about 50 holdings, mostly in financial services and technology, and he’s willing to let cash build (recently 15% of the portfolio) if he can’t find attractive investments. Top holdings: Semiconductor chip maker Synaptics…ServisFirst Bancshares, a regional bank in five southern states. Annual expense ratio: 1.04%. Performance: 9.6%.