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Market Update

Is It Time to Get Small?

Small-cap stocks took a beating last year, and despite the recent rebound, there are still good opportunities to be had.

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When news hit in October that  Valeant Pharmaceuticals (VRX) may have been recording false sales of products to one of its affiliates, the stock fell by 25% in one day. However, the claim also sank another part of the market: small-cap stocks.

At the time, the small-cap market was standing on shaky ground. Biotech stocks had been driving the sector higher for years, but runups in prices were starting to worry investors. Then, in September, Hillary Clinton said, if president, she would cap drug prices, which caused more concern. Then the Valeant accusations began to fly.

Fears over China's slowing economy, a Federal Reserve rate hike, and uneasiness around equities in general led to a major decline in small-cap stocks. Between June 24, 2015, and Feb. 11, 2016, the Russell 2000 dropped by 25%, a much larger fall the S&P 500's 13% decline over that same period.

"It was a bear market, and many people didn't realize it," says Frank Gannon, co-chief investment officer at Royce & Associates, which operates the small-cap focused  Royce Special Equity (RYSEX), which earns a Morningstar Analyst Rating of Gold.

Even though the Russell 2000 has climbed about 30% since Feb. 11, small caps may still have room to run. There are plenty of opportunities and a lot of positives--mostly related to the still expanding U.S. economy--that make small-caps solid long-term investments.

The Case for Small-Caps
To many investors, small-cap stocks are risky plays for speculative buyers. While some small companies fit that description, many smaller-cap stocks are long-term sustainable businesses that can find a home in any diversified portfolio.

If you look at valuations, small-cap stocks are reasonably priced.

Last year, the Russell 2000 peaked at about 25 times 12-month forward earnings. Today, the index is trading at about 22.6 times, says Joe Monahan, co-manager of  Conestoga Small Cap (CCASX), which earns a Silver rating from Morningstar. Historically, the Russell 2000 trades at between 15 and 24 times earnings, so while it's currently trading at the higher end of that range, it is below its peak.

Another way to look at valuations is to compare the valuation of the Russell 2000 to the S&P 500, says Monahan. At the moment, the Russell 2000 next 12 months price/earnings ratio is about 1.3 times the S&P 500's NTM P/E. Over the last decade, that ratio has averaged 1.4 times what the S&P 500 has been trading at.

While a lower valuation makes the small-cap space appear more attractive than the large-cap market, a stronger domestic economy also helps small-caps. A rising interest-rate environment, and a higher dollar, in particular, can give small-caps a boost over large-caps. How? Because when rates rise, the dollar tends to strengthen, which can hurt larger, more international companies that earn money in foreign dollars, says Monahan. As well, 83% of companies on the S&P 500 pay a dividend, while 52% of companies on the S&P SmallCap 600 pay one, meaning that when rates rise and bond yields become more attractive relative to stock yields, it's the larger dividend paying companies that will be affected most.

Finally, because small caps are usually more domestic-focused, labor market growth and increasing consumer confidence is good news for small stocks, says Monahan.

“When we saw slower revenues or earnings in other parts of the world, small-caps still managed to squeeze out sales growth and profits,” he says. 

The Value Shift
For many years small growth-oriented companies have received the bulk of small-cap investor attention, says Gannon. These are biotech, internet and other businesses that often didn't generate any earnings. As more people became worried about the overall economy late last year, access to capital dried up for many of these operations and stock prices tumbled.

As the small-cap market rebounds, investors have started to turn their attention to more value-oriented small cap fare, those companies that do generate revenues and can survive for the longer-term. Similar to the large-cap space, some of the sectors that have seen the biggest gains over the last few months have been more defensive industries, such as consumer staples, healthcare, and real estate investment trusts, says Gannon.

But while value-type stocks may be leading the charge today, investors who want to add a little more oomph to their portfolio may still want to consider growth-oriented stocks and funds, says Laura Lallos, a senior mutual fund analyst at Morningstar.

These funds have seen a disproportionate share of outflows over the past year--the small growth category has dropped from being the 19th biggest category to the 21st biggest, she says--and that presents an opportunity.

Not only have these stocks fallen harder than others, which may make them more attractive, but research shows that outflows can eventually translate into long-term success. 

"We have found that when a category has significant outflows, that can often be an indication that it's a good time to invest in the long-term," she says.

Some Small-Cap Investment Ideas
Morningstar has high ratings on a number of value and growth-focused small-cap funds and ETFs, but a few stand out. In the latter category, Alex Bryan, Morningstar's director of passive strategy research, recommends Vanguard's offerings.  Vanguard Small-Cap Value ETF (VBR) targets the cheaper half of the U.S. small-cap market. Bryan notes that the fund considers price/earnings and price/book metrics and weights its holdings by market cap. It has been 30% more volatile than the S&P 500, he says, but its 0.09% expense ratio gives it a leg up on its competition.

On the growth side, consider  Vanguard Small-Cap Growth ETF (VBK), says Bryan. With a 0.08% expense ratio, "it's one of the lowest-cost small-cap growth funds available, which gives it a sustainable edge against its peers," Bryan writes in his latest analysis. "Its broad, market-cap-weighted portfolio effectively diversifies risk, and it applies generous buffering rules to mitigate unnecessary turnover." The fund targets stocks with the highest growth rates and valuations ratios and weights companies by market cap, he adds.

When it comes to mutual funds, growth investors should look at Monahan's Conestoga Small Cap Investors fund, says Lallos. The managers  take a "patient approach to growth investing that has resulted in strong risk-adjusted returns within its category," she says. They pay particular attention to companies with strong earnings growth, high return on equity, low debt, and they like businesses where owners won a lot of the company stock.

On the small value side, Lallos recommends Bronze-rated  T. Rowe Price Small-Cap Value (PRSVX). It's well diversified, with a long-term and risk-oriented approach, she says. Manager David Wagner looks for companies that have strong return potential, are trading cheaply, and have lower risk. Since taking over in 2014, he has "toned down unintended factor bets in the portfolio, trimming names with currency and commodities exposure," she says.

For those investors who want to invest in smaller companies directly, there are currently 29 small-cap stocks trading in 4- or 5-star range, which means that these stocks are undervalued relative to their fair value estimates.

Two of Morningstar's favorites are  Carpenter Technology (CRS) and  Stifel Financial (SF). The former, which produces high-end specialty alloys and metals, is highly exposed to the quickly growing aerospace sector and that should help boost growth going forward, says Morningstar analyst Andrew Lane. 

"With oil and gas headwinds now abating, we expect Carpenter to enjoy substantial profitable growth in fiscal 2017 and beyond," he wrote in a July report.

For the latter company, Morningstar analyst Michael Wong says the full service brokerage and investment firm is benefiting from the same factors that are lifting all wealth management firms, such as a higher stock market and an expected interest rate increase. However, he says it should outperform peers due to company-specific reasons, too, "including optionality with its excess capital and a change in sentiment as it resumes its historical growth-company profile."

Ultimately, investors will have to decide what kind of company they’d like to own--a booming growth stock or a more value-focused operation--but they shouldn't pass up these smaller operations, especially today, says Gannon. He does expect to see more volatility in the near future due to uncertainty around the election, the Federal Reserve's rate decisions and general worries over the global economies, so investors could wait for another dip to buy in. But, in general, people can't go wrong with high-quality buys. 

"There are great business out there that meet the merits of quality and value," he says. "It's these companies that will benefit from the power of compounding."

 Bryan Borzykowski is a freelance columnist for Morningstar.com. The views expressed in this article do not necessarily reflect the views of Morningstar.com.


Bryan Borzykowski does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.