If you believe Jack Fockler of Royce Funds, this could be merely the beginning of an extended bull market for small-cap stocks. "If the type of environment of the past two years persists for a few years," Fockler says, "then small caps are going to do well."

And not just small caps in general, but small value in particular. Indeed, Fockler recently wrote a report titled The Case for Small-Cap Value Investing in which he marshaled a series of statistics intended to prove that small-cap value might be the market's next sweet spot.

Of course, Royce Funds is hardly a disinterested observer. The shop has no fewer than nine small- and micro-cap mutual funds, plus three closed-end small-value funds, and it manages about $6 billion in its chosen part of the market. At the beginning of February, flagship Pennsylvania Mutual (PENNX) had a Morningstar category rating of four, thanks to above-average returns and below-average risk versus its small value peers. If small-value really does hold the market lead, Royce Funds stands to benefit handsomely.

This may indeed be the best of times for small-cap value stocks, for at least three reasons: reversion to the mean, momentum, and lower large-cap returns.

Reversion To The Mean

The simplest argument in small-cap value's favor is reversion to the mean, a fancy statistical term that simply means that no asset class stays up or down forever. At some point, because of changing psychology, a shift in management, or what have you, laggards and leaders change places.

Small caps lagged for much of the growth-driven bull market, and it's only recently that investors have noticed that part of the market. "Small caps have been delivering real growth for the last several years," says Fockler, "but no one has paid attention till now."

Given that both small caps and value were out of favor for so long, a belief in reversion to the mean would support a belief in small value's continued strength.


Everyone loves a winner, and perhaps nowhere is that more true than in the stock market. No sooner does a part of the market begin to rise than investors crowd into it, pushing stock prices up further, attracting even more investors, which leads to higher prices, and so on. Such a circle helped fuel the gains of technology stocks during the latter part of the 1990s' boom.

"The market operates on momentum," Fockler says. "Small caps have outperformed for about two years, and we're still early in this game. I think we've got two or three more years where small caps have an edge."

While small caps on the whole have performed well, small value has performed the best. As of January 25, small-cap value funds had the highest trailing three-month and one-year returns of any of Morningstar's domestic-stock categories. There's no guarantee that such trends will hold, of course, but if they do, investors are bound to notice, resulting in more dollars that will push up returns.

Lower Large-Cap Returns

Very few market observers believe that large-cap stocks will resume their upward momentum any time soon. In fact, recent estimates of future stock market returns fall somewhere in the 6% to 8% range. But while the market, as most investors conceive it, consists of large caps, small-cap stocks don't necessarily follow their lead.

Perhaps Fockler's most interesting chart is one that shows how small caps have fared in lower-return environments. Fockler first divided 10-year S&P 500 returns into quintiles from lowest to highest. (See page 98.) He then marked the top two quintiles as high-return market periods, and the bottom three as low-return periods. For each ten-year time period, Fockler compared the return of small caps as measured by the CRSP 6-10 Index.

What Fockler found was that when large caps were on a roll-i.e. returning more than 14.3% over a 10-year period-they outperformed small caps. But when large caps returned less than 14%, small caps took the lead. In fact, of the 159 lower-returning periods from December 1935 through September 2001, small caps outperformed in 81% of them.

And if you like small caps, you've gotta love small value, because Fockler's figures show that in past cycles of the small-cap-focused Russell 2000 index, value stocks have outperformed in four out of six trough-to-peak periods.

So if any of the above scenarios plays out-and no one knows whether they will-investors may soon be talking about small value the way they used to speak of large growth. Which would make Jack Fockler and other small-value managers very happy indeed.

Olivia Barbee is editor of MorningstarAdvisor.com. More information on Royce Funds can be found at www.roycefunds.com or in the Due Diligence section of MorningstarAdvisor.com.