Play small! Large-caps ain’t the only game in town

With all the recent attention on the record-setting performance of the broad market indexes, it’s easy to forget that small-capitalization stocks are also doing well.

Although some quantitative analysts are forecasting a rotation out of small-caps and into larger-company stocks as indexes such as the S&P 500 gain steam, not everyone subscribes to the separation theory.

“In periods of subpar economic growth like now, small-caps outperform large-caps by close to a 2-to-1 margin,” said Dan Veru, chief investment officer at Palisade Capital Management, which manages nearly $5 billion, half of which is in small-cap portfolios.

There is no denying the significance of the record high set last month by the S&P 500, giving the benchmark a 10.1% gain from the start of the year.

“MORE NIMBLE’

But the smaller-cap-focused Russell 2000 Index, which set its own all-time high in January, is still chugging along with an 11.1% gain so far this year.

The small-cap-growth category, as tracked by Morningstar Inc., has gained 10.6% over the same period.

“The reality is, those large-caps are not growing their top-line [revenue],” Mr. Veru said. “Small-caps tend to be more nimble.”

To Mr. Veru, that adds up to more consolidation, which is usually good for small-cap investors.

“If you’re a big company trying to put that cash to work, you might as well put it into an acquisition,” he said. “In this economy, combined with all the new regulations, you need critical mass more than ever.”

Over the past nine quarters, 35 of Mr. Veru’s small-cap holdings have been acquired, at an average premium of 38%.

The Highland Small-Cap Equity Fund (HSZAX), subadvised by Palisade, has gained 10.7% this year and was up 13.7% last year.

SMALLEST OF THE SMALL

Marc Roberts, co-manager of the FAM Small Cap Investor Fund (FAMFX), also is committed to finding small-cap opportunities, regardless of the market cycle.

His fund, launched a year ago, concentrates on the smallest end of the small-cap space.

The portfolio of just 23 stocks is designed to take advantage of market inefficiencies among companies with market caps of between $50 million and $1 billion.

With a highly concentrated portfolio and an annual turnover rate of less than 10%, Mr. Roberts considers the fund a value strategy, even though Morningstar categorizes it as small blend.

The fund has gained 9.3% so far this year, compared with an 11% gain by the small-blend category.

“It’s hard for large [research firms] to focus on the kinds of small companies we own,” Mr. Roberts said.

One of the fund’s largest holdings, Amerisafe Inc. (AMSF), is an insurance holding company that underwrites workers’ compensation insurance in high-risk industries.

The company has a market cap of $640 million, and the stock is up nearly 30% this year.

Another example off the beaten path is Fabrinet (FN), a manufacturer of optical components.

The $480 million company has had an across-the-board “sell” rating from Wall Street analysts for the past year, but Mr. Roberts is focused on the company’s cash stockpile and a nearly 30% gain on invested capital.

The stock is up almost 7% this year.

“The Street is always focused on a short period,” he said. “But we love these niche companies.”

Mr. Veru agrees that small-cap managers thrive off the beaten path, which is rarely what you get with the beta exposure in large-cap stocks.

For example, one of Mr. Veru’s favorite stocks, short-line railroad operator Genesee & Wyoming Inc. (GWR) was a microcap stock just a few years ago but now has a market cap of nearly $5 billion.

The stock, which is riding the wave of growing energy transportation demands, has gained more than 20% this year and is up more than 67% over the past 12 months.

“There’s a perception that you’re taking a risk with small-caps, but when you look back at 80 years of data, it’s rare when large-caps outperform small-caps,” Mr. Veru said. “It’s human nature for people to sometimes want what’s big and comfortable, but we get hired to make money for people.”

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