Though smaller companies have lagged behind bigger ones, they are staging a recovery and could be well-positioned to keep going—especially if the latest concerns about the economic recovery ease.
For investors looking for a way to tap into the prospects for smaller companies, active funds may be an option since many are beating the index.
After the market clocked another high and megacap technology companies hold firm to their dominance, some investors are looking to diversify.
One way is to pay more attention to smaller companies. Small-cap valuations, using enterprise value to earnings before interest, taxes, depreciation, and amortization, or Ebitda, have fallen in August from 17.5 to 16 times, marking the largest decline since the beginning of the pandemic and the gap between the valuations of large companies and small ones is at its lowest level in a year, writes Barclays strategist Venu Krishna.
The earnings outlook for smaller companies is also improving, with Ebitda margins at their highest point since 2015, sales growth improving, and leverage falling down to 2016 levels.
Smaller companies have also hit an inflection point, Krishna notes, with buybacks increasing for three consecutive months. Though still down 26% from prepandemic levels, Krishna sees the latest trend as an indication smaller companies are on the road to recovery after a period of conserving cash in the throes of the pandemic.
One way to take advantage of the opportunity is through mutual funds. Nearly 90% of small-cap core mutual funds, for example, are outperforming the Russell 2000 so far this year, writes Goldman Sachs ‘ Cormac Conners.
Barron’s screened Morningstar Direct to find small-cap mutual funds that are both open to new investors and have beaten at least two-thirds of their peers over the last three years and year to date. We whittled the group down to those with at least $300 million in assets and accessible to retail investors—and found a handful of funds to consider, with many tilted toward value screening better.
Several of Fidelity’s small-cap funds screened well, including the $4 billion Fidelity Small Cap Value Fund (FCPVX). It takes a quality approach, looking for companies that can consistently grow—so-called compounders—as well as deep-value companies and those that are somewhere in between. The fund has a higher allocation—almost 10%— to information-technology companies than its peers and to materials, which accounted for almost 8% of the portfolio at the end of July. The fund’s 13% average annual return over the past three years beat 93% of similar funds.
The $3.4 billion AB Discovery Value (ABASX) is underweight healthcare with less than 2% of assets in the sector and has about a fifth of assets in cyclical stocks compared with the 14% on average for others. The fund’s 29% return so far is beating 72% of its small-value peers.
The $7.2 billion Undiscovered Managers Behavioral Value (UBVAX) fund often hunts for companies with substantial insider buying or stock buybacks that are cheap and have strong fundamentals. About a third of assets are in financials, more than the average of 24% for others, and it has less in healthcare than its peers.
The $5.5 billion Baron Small Cap (BSCFX) fund has a heftier allocation to industrial and technology companies and less in financials. Manager Cliff Greenberg is known for his patience in companies with sustainable growth and the ability to ward off competitors—and he is known for sticking with them, even when they grow out of the traditional small-cap arena. While the fund’s 1.3% expense ratio is above average, its 19% return over the last three years has beaten 70% of its peers, according to Morningstar.
The $5.5 billion Fuller & Thaler Behavioral Small Cap Equity (FTHNX) tends to hold more undervalued stocks and tilts toward more quality stocks—those with consistent profitability and growth, and solid balance sheets—as well as companies that pay dividends or buyback stock. So far this year, the fund’s 27% return beats 87% of its peers, according to Morningstar.
The $527 million Pimco RAE Plus Small fund (PCFAX) is a systematic fund that finds stocks incorporating quality and momentum signals and then weighs them based on factors like size, cash flows and book value. That has taken it to energy, with more than a fifth of the fund allocated to the sector—in contrast to energy’s 6.5% weighting in the index. The fund returned 34% so far this year, beating 93% of similar funds.
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