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Hot small-cap funds you can still buy
Small-cap stocks historically lead the market as the economy pulls out of tough times, but getting in on a good small-cap fund is no easy task.
By Timothy Middleton
I beat the drum for small-company stock funds at every opportunity.
By happy coincidence, I recommended them in March 2000, just as the bear market was beginning. In the intervening years, they have beaten the pants off of big-company funds, albeit by losing less money -- 7.1% a year, according to Morningstar, compared with 12.6% for big-cap funds.
I also recommended them last September, when stocks were taking a shellacking and small stocks were being pasted particularly. (I reminded readers of that advice at the year's end.) This year, through May 26, the average small-company growth fund is up 8.5%, leading large-cap funds by a full percentage point.
Its time to recommend them again. In fact, says one of my favorite small-cap managers, Tom Barry, this is the absolute perfect time to invest in such funds.
Why? Small-company stocks always do better than their bigger rivals in certain circumstances, notably when the nation is emerging from recession. Since the 1970s, small caps have delivered average returns of 39.3% in the 12 months following recession, nearly double the return of the S&P 500 ($INX) during those months.
There's every reason to believe the current recession (as defined by the National Bureau of Economic Research) is ending and that financial history is about to repeat itself.
The problem
The only problem with taking advantage of this trend is that buying outstanding small-company funds is damned hard. The best -- including Barrys fund, Bjurman Barry Micro-Cap Growth (BMCFX) -- are closed to new investors; some are even closed to existing shareholders. And indexing, a no-brainer strategy with big-cap stocks, isnt as easy with small caps.
Small caps outperform at times like this for two reasons: First, uncertainty about stocks as an asset class diminishes as the economic picture brightens. Second, small companies have the agility to take advantage of a rebound more quickly than their larger rivals do.
| Returns for the year after a recession | | Recession end | Small cap | Large cap | Spread | | 11/30/70 | 22.7% | 16.9% | 5.8% | | 3/31/75 | 56.6 | 27.2 | 29.4 | | 7/3/80 | 44.1 | 20.5 | 23.6 | | 11/30/82 | 37.0 | 27.9 | 9.1 | | 3/31/91 | 36.2 | 16.0 | 20.2 | | Average | 39.3 | 21.7 | 17.6 |
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Note: Small cap is total return of 7th and 8th deciles of market capitalization; i.e., not micro cap, which are deciles 9 and 10. Large cap is S&P 500. Sources: Ibbotson Associates, National Bureau of Economic Research
Of course, it may be that the nation isn't emerging from recession: The arbiter, the National Bureau of Economic Research, hasnt declared an official end to the downturn that began in March 2001, exactly one year after the bear market began.
The group gives scant attention to gross domestic product, which has been growing, focusing instead on employment and real personal income, both of which continue to shrink. The bureau regards employment growth as the single most important indicator of an economic recovery.
By the same token, however, the recession will be over long before this group makes it official. The end of the last recession, which finished running its course in March 1991, wasnt certified until December 1992. So Ill go with GDP, which has been positive for four consecutive quarters, and declare the recession over now.
Another advantage
In todays world, where Japan and Europe continue to lag U.S. growth, small stocks have the further advantage of relying less on foreign earnings than big companies. This natural edge is dulled at the moment because the U.S. dollar is weak against the euro and the yen, but that circumstance is a net plus for the domestic economy, giving back some zip to small companies.
The advantages that accrue to small stocks during times like these are so great that they overwhelm the periods when big companies assert market leadership. Ibbotson Associates calculates that since 1926, small stocks have delivered annualized returns of 12.1%, compared with 10.2% for large stocks.
Some, but not all, small stocks are also considered the best possible equity investments under all circumstances. Research by Eugene Fama and Kenneth French, a pillar of efficient-markets theory, finds that small-cap value stocks are the single best kind to own.
The research is controversial. Fama and French base their analysis on the claim that such stocks deliver the highest returns because they're the riskiest in the marketplace -- but their argument is a tautology, with risk defined as that which produces the most returns.
Traditional value investors say that a high price-to-book value ratio, which is what Fama and French use to define value stocks, means the stock is less risky than stocks in general because its market price is relatively low.
Some disagree, sharply
If you subscribe to Fama/French, half the small-cap universe -- the half described as growth stocks -- is denied to you. Shrieks William J. Bernstein, a Fama/French bull and author of "Intelligent Asset Allocation": The larger point is simply not to buy small growth funds at all -- this is a miserable asset class. (Italics in the original.)
As the unrepentant owner of more than one small growth fund, I disagree.
Fama and French have a fairly successful demonstration of their theory, however, in the form of a mutual fund, Dimensional US Small Cap Value (DFSVX), which historically -- but not in the last three years -- has ranked among the top third of small value mutual funds.
Although High Church indexers like Bernstein disagree, indexing doesnt work well with small stocks. Partly the issue is a matter of design. The most common small-cap benchmark, the Russell 2000 Index, is the smaller 2,000 of the 3,000 largest stocks in the marketplace. Indexers incur transaction costs, and sometimes tax liabilities, every time it's rebalanced.
Vanguard Small Cap Index (NAESX), which tracks the Russell 2000, has never finished in the top half of Morningstars small-blend group, and most of the time its in the bottom third. (Vanguard has announced it's seeking a new index for the fund to follow.)
Dont use the Russell index, says Larry Swedroe, director of research for Buckingham Asset Management, a St. Louis advisory firm. The S&P 600 ($SPCY) is better, or the (Dimensional) fund, if you have access.
An exclusive club
Access is a key issue with Dimensional funds. Swedroe is among the small number of investment managers that Dimension Fund Advisers allows to invest in its funds, to hold down shareholder costs. Some 401(k) plans also provide entry.
To exploit the S&P 600 index, buy iShares S&P Small Cap 600 Index (IJR, news, msgs), an exchange-traded fund.
Among traditional mutual funds, small-cap pickings are slim. Of the 25 funds with the best 10-year performance records, 16 are either closed to new investors or have high minimums to keep out retail investors.
Of the top five over the last five years, four are closed. The exception, Kinetics Internet fund (WWWFX), is a sector rather than a small-cap fund.
Here are a handful of small-cap funds with at least five years of excellent performance still open to new investors.
| Top small-cap funds you can still buy | | Fund | Category | 3-year % rank | 5-year % rank | | CGM Focus (CGMFX) | Blend | 1 | 1 | | FBR Small Cap Val A (FBRVX) | Growth | 1 | 7 | | Bridgeway Ultra-Sm Tax Ad (BRSIX) | Blend | 2 | 4 | | Fidelity Low-Priced Stock (FLPSX) | Blend | 2 | 8 | | RS Partners (RSPFX) | Value | 3 | 23 | | Royce Special Equity (RYSEX) | Value | 4 | 1 | | Ariel (ARGFX) | Value | 10 | 10 | | FAM Equity-Income (FAMEX) | Value | 11 | 13 | | Delafield (DEFIX) | Value | 11 | 15 | | Royce Total Return (RYTRX) | Value | 20 | 9 |
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Note: As of 4/30/03
Source: Morningstar
According to Ibbotson, the periods during which small-cap stocks outperform last at least several years, and sometimes more than five. So even though theyve been doing well lately, theres every reason to expect theyll continue to perform nicely.
There are strong arguments in favor of trying to market-time investments in small caps, since their outperformance tends to clump up. Their greatest period of outperformance in history occurred after the market crash of 1973-74, and subsequently they went back into hibernation.
An issue of timing?
Ken Winans, an investment adviser in San Francisco, notes that over the 15 years ended Dec. 31, 1999, not a single small-cap fund in the Morningstar database beat the S&P 500 Index.
But over the 15 years ended Dec. 31, 2002, 36% of them did. The collapse of leadership by big technology stocks early in 2000 proved such a strong predictor of rotation to small-cap dominance that I and many other market observers had no difficulty picking it up.
The problem with timing, however, is that even when powerful trends are at work, Wall Streets day-to-day lurch is so unpredictable your analysis is constantly defied. For most of last year, small-cap funds did terribly.
In my own portfolio, I own small caps all the time. Sometimes I vary the mix. I added to my holdings in the bear market, and will trim them at some point I cant yet foresee. But I believe in diversification. As with the ends of recessions, big shifts in securities markets are far easier to see in retrospect than they are at the time.
At the time of publication, Timothy Middleton controlled shares in the following securities mentioned in this article: Bjurman Barry Micro-Cap Growth Fund.
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