The beginnings of most bull markets are marked by a strong rally in lower-quality small company stocks, and this one has been no different, says Jenny Jones, who manages the Schroder U.S. Small/Mid Cap Equity Fund. But, she adds, investors who expect more of the same next year are likely to be disappointed.
"So far, the rally in small caps has been strongest among the tiniest, lowest-quality companies," she says. "While that's fairly typical coming out of the recession, I've been somewhat surprised by the strength and quickness of the move." According to her firm's research, stocks with the lowest public value rose an astounding 193% through the third quarter of 2009, while stocks of companies with no earnings have shot up 46%. By comparison, the Standard & Poor's 500 index was up 19.3% over the same period.
But Jones expects a shift as investors reassess the economy and take stock of market valuations. "If we are indeed in the midst of a recovery, then market leadership will likely shift toward higher-quality companies next year," she says.
The improvement in earnings that Jones anticipates from now through 2010, particularly in areas driven by improving consumer demand, could give stocks more running room. Some of that demand will likely come from dormant consumers whose portfolios are perking up again thanks to the stock market rebound. "The fact that the wealthiest 10% of consumers are feeling a lot better about their financial situation these days has been largely overlooked by both analysts and the media," she observes.
Although valuations are not nearly as attractive as they were at the market bottom in March, Jones believes that stocks "are not egregiously priced" based on long-term averages. At the same time, she is troubled by the rebound in commodity prices. Since stock and commodity returns typically go separate ways, rising commodity prices are usually not a good harbinger for equities.
Assuming the stock market rally stays on track, small-cap stocks should do well relative to large caps in the coming months, she says. Stocks of smaller companies typically race ahead for the first 12 to 18 months after the beginning of a market rally. Since the market appears to have hit bottom in March, their relative outperformance could persist over the next few months.
Jones is particularly enthusiastic about both large and small companies that derive a substantial portion of their revenues from exports, since they stand to benefit from what she believes will be a continued weakening of the U.S. dollar. Many of the companies in the portfolio, whose market capitalizations range from $750 million to $7 billion, fall into that category. "It's a common misperception that small- and mid-cap stocks benefit less from a weaker dollar than large caps," she says. "In fact, there is no evidence that a weak dollar leads to outperformance by large-company stocks."
Covering The Bases
To cover a range of different stock market scenarios, the fund's 70 to 90 holdings fall into one of three categories. The mispriced growth portion of the portfolio concentrates on stocks whose prices understate the growth potential of a company. These usually represent 50% to 60% of the fund's assets. While they tend to earn the highest returns for the fund in rising markets, they are less resilient in negative market environments. Steady eddies, which make up 20% to 50% of the fund, are companies with recurring revenues and strong cash flows. While their growth rates are typically not as high as those of the mispriced growth stocks, they tend to have more consistent earnings and hold up well in declining markets. Turnarounds, which account for up to 20% of fund assets, are stocks of companies that have suffered some type of misfortune but have a catalyst for improvement.
Their performance is less predictable than that of the other two groups relative to overall market conditions, but they can pep up performance if a turnaround materializes.
In addition to spreading its bets among stocks with different fundamental characteristics that prosper in different market cycles, the fund employs a number of other strategies that both smooth out returns and keep it at the more conservative end of the small/mid-cap investment spectrum. Each stock can account for no more than 5% of fund assets, and sector weightings can deviate no more than 10 percentage points from the weightings in the fund's benchmark, the Russell 2500 Index. Analysts set exit prices before purchasing a stock, though that target may change at some point, and maintain a typical holding period of between two and three years. The cash balance typically ranges from 5% to 10% of assets.