Financial advisors trying to persuade conservative investors to take on the volatility and risks of smaller companies in exchange for possibly higher returns face a tough sell. Yet there is one approach that takes some of the drama out of investing in small caps, and it doesn’t sacrifice the upside potential.
Christopher Beck, longtime manager of the $755 million Delaware Small Cap Value Fund, says that some smaller companies in the value camp boast attractive features, including strong cash flow and low debt, that appeal to more conservative investors.
“Historically, small-cap value stocks have also experienced less volatility and better returns than small-cap growth stocks,” he says.
Research by Delaware Investments backs up his observation. It shows that in 20 of the last 31 years, the Russell
2000 Value Index has outperformed the Russell 2000 Growth Index—with a lower standard deviation (a measure of volatility).
But there have been some years when small-cap growth stocks outperformed their value cousins by a wide margin. It happened during the tech bubble of 1999, although much of those gains were wiped out during the tech crash the following year. It also happened to a lesser extent in 2007 and 2009 as investor appetite for speculative fare increased.
Value stocks, meanwhile, have at times lost some of their safety: With increased market volatility in recent years, their standard deviation has moved closer to that of small growth companies.
Small value stocks have some things in common with their better-known larger company counterparts. Their prices are cheap for their earnings growth, cash flow and other financial yardsticks. They are often concentrated in economically sensitive sectors such as industrial companies, financial services and consumer discretionary goods businesses. And as a group, they pay higher dividends than growth stocks (the 2% dividend yield of the stocks in the Russell 2000 Value Index come mainly from the utility, real estate investment trust and financial sectors).
But unlike their large counterparts, many small-cap value names are unfamiliar to investors and under-covered by stock analysts. That anonymity gives intrepid investors the chance to find undiscovered gems and avoid some of the hype and herd mentality associated with big names.
For financial advisors setting up year-end asset allocations in client portfolios, the question is whether this is a good time to devote more or less portfolio space to small company stocks in general and small-cap value stocks in particular.
Recent market cycles might shed some light on the issue: Coming out of the stock market debacle of 2008, stocks of smaller companies outperformed those of larger ones, a typical pattern at the beginning of a bull market. More recently, the tepid pace of the economic recovery and concerns about investment risk have drawn investors to more conservative, larger company stocks. In 2011, the iShares Russell 1000 Index ETF (IWB), which follows large company stocks, rose 1.36% while the iShares Russell 2000 Index ETF (IWM), tracking smaller companies, fell 4.2%. Through September 30, the large company ETF is up 16.2% for 2012, beating the small-cap ETF by about two percentage points.
The rotation from small caps to large caps has been a textbook stock market recovery, says Beck. He adds that at this point, the valuations on both sides of the fence are in line. If the mild economic recovery continues, he believes small and large company stock performance should be fairly similar. But if there are continued fears of recession, “small caps are going to be more volatile than large caps,” he warns.
Large companies still hold an edge when it comes to sales to overseas markets. According to Beck, larger companies often derive 45% to 50% of their sales internationally, while smaller ones make only 15% to 20% of their sales overseas.
But he believes that since China’s growth is slowing and people are concerned about a weak recovery in Europe, the perceived advantage of strong foreign sales could be waning. “Right now, it looks like a kind of purgatory period. Investors aren’t really sure whether more overseas exposure is a positive or a negative.”
Barring a sudden downturn in the economy, he expects merger and acquisition activity among smaller companies to pick up next year. On how small-cap value compares with small-cap growth, the fund’s most recent letter to shareholders opined that if the rebound in the economy continues to be modest, “stocks of higher-quality companies with free cash flow may continue to outperform the more speculative areas of the market.”
Beck’s fund typically owns 95 to 100 stocks and maintains a modest allocation of about 20% of assets in its top 10 holdings. He’s dedicated to small companies—his median market capitalization is $1.6 billion—and holds on to most of his picks for several years, citing a portfolio turnover rate of just 29%.
To qualify for the portfolio, companies must generate strong cash flow and use it to pay dividends, buy back stock, pay down debt or make acquisitions. Beck looks at a company’s revenue over the past three years and compares that to its growth in capital spending. If that spending winds down while revenue picks up steam, it could augur better cash flow. By the same token, he avoids companies where increased spending and falling revenue could choke off cash flow. He also looks at companies’ price-to-earnings and price-to-book values, though these vary from sector to sector.
The fund has a larger position in the consumer services sector than its bogey, the Russell 2000 Value Index. Beck says portfolio companies in this sector such as the Cheesecake Factory Inc. and Brinker International (the parent of restaurant chain Chili’s) have strong cash flow and reasonable valuations, and are in a good position to take advantage of modest growth in the economy and consumer spending. “The Fed has eased monetary policy over the last two years and has signaled its intention to continue doing so for the next two years,” he says. “We see that as a signal that the Fed wants to see growth and isn’t concerned about inflation.”
On the other hand, the fund has been underweight in more defensive sectors such as real estate investment trusts, a stance that has hurt its performance this year as yield-hungry investors continued to bid up the price of those stocks. “While our underweight in REITs has meant that we’ve lost out on some positive returns because of their continued strong performance, we continue to believe they are overvalued and that our underweight position is a sound one from a risk/reward perspective,” Beck says.
While the fund has also been underweight in the financial sector for most of the last decade, Beck has been edging back into some institutions that have seen a decrease in nonperforming loans. But with loan growth still spotty, he’s not jumping in with both feet, and he remains somewhat underweight in the sector.
He recently added to the fund’s position in East West Bancorp, which caters mainly to the Asian-American community in the Los Angeles area. In 2008 and 2009, the bank saw a rise in nonperforming loans as the recession took hold. But a move by the bank’s management to aggressively identify these loans and take early losses on them allowed it to clear the deck for later improvement. At the end of 2009, the bank acquired United Commercial Bank, expanding into San Francisco, and East West’s improved cash flow has meanwhile allowed it to raise dividends and buy back stock.
Beck also owns bank holding company Community Bank System (CBU), which has a strong presence in Upstate New York and Northeast Pennsylvania. With its strict underwriting standards, CBU has had fewer nonperforming loans than other banks, and the stock carries an attractive 4% dividend yield. Beck views it as an income play that sits well alongside loan growth stories like East West’s.
Teleflex, another Beck fund holding, was a conglomerate until two years ago, when it began selling off its industrial and aerospace operations to focus on catheters and other health-care products. Beck says narrowing its product line and selling off divisions allowed the company to raise cash, pay down debt and offer investors a 2% dividend yield on the stock.
He also holds Glatfelter, a specialty paper manufacturer. Because its market capitalization is just $760 million, the company flies under the radar of most investors. But it has a number of attractive features, including a solid niche as a maker of the thin papers used in tea bags and single-serve coffee bags. Its stock sells for a reasonable 12 times estimated 2013 earnings, and strong cash flow has allowed the company to aggressively buy back its shares. Furthermore, the company’s restrained spending should help it protect its future cash flow.
“I’ve met with management, and they’ve made it clear that they’re not about to go on a capital spending binge,” says Beck.