The stock market's nose dive beginning last fall effectively redefined small-cap stocks, which provided at least a temporary advantage to smaller money managers and individual investors over many of the asset management behemoths.
Although smaller-company stocks have led the way in performance since the March 9 stock market low, many of those stocks are only now moving into a market capitalization range that meets the size and liquidity requirements of most large institutional money managers.
“It's been increasingly difficult for institutional money managers to exploit opportunities the way they did in the past,” said Bob Straus, chief investment officer at Icon Advisers Inc.
Mr. Straus, whose firm manages $2 billion, acknowledged that “from a pure trading perspective, it certainly makes sense that the smaller investor would have an advantage.”
The advantage was created by broad economic forces that drove down the entire stock market, and that had a unique impact on managers of small-cap stocks because it pushed those stocks that are generally expected to lead a market recovery beyond the range of some big fund managers.
“It's hard for a billion-dollar fund to take a significant position in these smaller stocks, and we've seen a big performance move by smaller stocks,” said Chris Tessin, a small-cap portfolio manager with Russell Investments, which has $152 billion under management.
The market cap shrinkage was illustrated by the annual re-balancing of the Russell 2000 Index on June 29.
The market cap of the smallest company in the index dropped to $78 million, which was down 53% from $167 million last year.
At the 2007 re-balancing of the index, the smallest market cap was $262 million.The last time the bottom end of the index market cap was this low was 1993.
“It is unusual to see the stock market drop the way it did, but it's even more unique this year because so many stocks moved down into a range where institutions have trouble buying them,” Mr. Tessin said.
For some money managers, the best way to compete was to alter the market-cap definitions.
“When you go through a period like 2008 when everything got whacked, you had to rejigger your thinking,” said John Buckingham, chief investment officer at Al Frank Asset Management Inc., an all-cap money manager with $450 million in assets.
Traditional strategies usually define small-cap stocks as those with a market cap of less than $2 billion, and large-caps as those with more than $10 billion, with mid-caps filling the gap in the middle.
Mr. Buckingham decided to divide the Russell 3000 Index into five equal quintiles, and by designating the bottom two quintiles as small-cap, he is able to define companies with a market cap as large as $17 billion as small-cap.
“We've just gone through one of the worst market periods, followed by one of the best market periods, and the definitions of “small-,” “mid-” and “large-[cap]” have been moving targets,” he said. “The rules, if you have them, have to be revisited.”
In the case of the firm's flagship, the $125 million Al Frank Fund (VALUX), the broader definition of “small-cap” hasn't hurt performance.
Year-to-date through last Wednesday, the fund was up 31.5%, compared with a 20.5% gain by the S&P 500.
The fund is slightly lagging behind the 33.1% average return of Morningstar Inc.'s mid-cap-blend category.
But though expanding the size of the small-cap universe might help a go-anywhere fund, a lot of small-cap managers have been forced to take a more deliberate approach toward stocks that ordinarily would be too small to consider.
“Things really got carried away earlier this year, and a lot of those smaller companies were half-billion-dollar companies just a few years ago,” said Jim Tringas, who manages $1.7 billion in two small-cap funds at Evergreen Investments.
Although he has the flexibility to invest up to 20% of a portfolio beyond the $2 billion small-cap range, he is limited by such market forces as liquidity in terms of the low end of market cap.
“Unless a company has a $200 million market cap, we're pretty much locked out,” Mr. Tringas said. “I do think somebody with a pretty sharp pencil or somebody running a small fund might have some opportunities there, but I also think that window is rapidly closing.”
TAKING A CHANCE
Three months ago, when the temptation was too strong to resist, Mr. Tringas did take a chance on Furniture Brands International Inc. (FBN), which was trading below $4 and had a market cap of close to $150 million.
The stock, which briefly dropped below $1 a share in March, now trades at nearly $6 and is up 167% from the start of the year.
One reality that helped Mr. Tringas take a position in such a small stock was the market downturn; he is now managing half as much money as he was a few years ago.
Thus, having a smaller portfolio, he can gain exposure to some small stocks without triggering a Securities and Exchange Commission filing that is required when ownership exceeds 10%.
Year-to-date through Wednesday, Mr. Tringas' Evergreen Special Values Fund (ESPAX) had gained 27.4%, which is in line with the Morningstar small-cap-value category.
“We're up 80% off the market bottom, and it has absolutely been led by the lowest-quality companies,” he said.
E-mail Jeff Benjamin at [email protected].
