Is It Time To Think Small?

By Aaron Levitt | October 25, 2011 AAA

While the global economy has continued to plod along, investors have sought to dial down their risk profiles. Cash, bonds and precious metals have become the investments du jour for a variety of retail and institutional portfolios. For those choosing to hold equities, the preference has gone towards large and mega-cap stocks. Funds like the iShares S&P 100 Index (NYSE:OEF) have seen massive inflows of new money, as investors have sought dividends and safety. However, as investors have scrambled to get into the largest of firms, small caps have fallen by the wayside. For those willing to take on some risk, there are plenty of opportunities in small-cap space that could offer some big returns.

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Recent Underperformance

Since volatility has returned to the stock market this summer, the small-cap surge seems to have ended. The proxy for the sector, the Russell 2000 Index, plummeted 18.33% this year from May 2 to Sept. 8. This is nearly 50% worse than the large-cap based S&P 500 Index's fall of 12.18%. Overall, investors have pulled over $13 billion from small-cap funds from May to August. What's more shocking is that during the height of the Great Recession, fund outflows from smalls didn't even come close to that amount. With sentiment for smaller firms so negative, now could be the best time for a contrarian investor to add the sector to a portfolio, and there's plenty of reason to do just that. (For further reading, check out What it Means to Be Contrarian.)

Since the Great Depression, small caps have done well in long-term secular bear markets. If the market continues to move sideways for an extended period of time, firms with smaller market capitalizations should do well. Due to their agility, small companies have a tendency to benefit more quickly from economic rebounds. Once the economy finally gets going and shows some resemblance to normal patterns, small caps will certainly fall back into favor. In addition, the Federal Reserve is giving smaller firms a present, by keeping interest rates low for an "extended period of time." These companies will be able to buy more equipment, increase hiring and produce more goods cheaply. Due to their size, all of these things will quickly manifest themselves in small-cap bottom lines and revenue. Finally, another reason to add the sector is valuations for the stocks themselves. The iShares Russell 2000 Index (NYSE:IWM) traded for a P/E of about 21.75, as of Sept. 30; that's down from a year earlier, when the index was trading at an insane 79.29 times earnings.

Think Small
For those investors who want to avoid the herd and take the other side of the trade, the small-cap sector is an interesting buy right now. Funds like the Vanguard Small Cap ETF (NYSE:VB) and iShares S&P Small Cap 600 Index (NYSE:IJR) make adding a swath of domestic small caps to a portfolio easy. However, there are plenty of other ways to add that exposure. Here are a few picks.

Small-cap investing is one area of the market that active management can really pay off, and no one does it better than Royce Associates. The mutual fund firm has dedicated itself to all things small and runs a plethora of small-cap based mutual funds. One of their more compelling offerings is their Royce Value Trust (NYSE:RVT). The CEF is trading at 14% discount to NAV and has shattered the broad Russell index, since its inception in 1986. $10,000 invested in the Royce fund at inception, would be worth about $98,000, today; had you picked the index, you would have about $31,000 dollars less.


For those who want to think even smaller, micro-cap firms could add some extra juice to portfolio. The iShares Russell Microcap Index (NYSE:IWC) tracks over 1400 different firms, including Peet's Coffee & Tea (Nasdaq:PEET) and Shuffle Master (Nasdaq:SHFL). The fund also pays a surprisingly high yield of 1.55% and offers plenty of diversification. Investors can also use the PowerShares Zacks Micro Cap (NYSE:PZI), which offers a more concentrated portfolio of stocks. (For a closer look at analyzing companies with smaller market caps, read How To Evaluate A Micro-Cap Company.)

The Bottom Line
With investors running from risk, the small-cap sector seems ripe for the picking. Valuations have come down from their highs and the sector could rebound higher, when the economy finally gets back on track. The previous funds along with the Rydex S&P Small Cap 600 Pure Growth (NYSE:RZG) make great ways to play the sector.

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