"The continuing low rates and the Bernanke 'put' have allowed the undertow of speculation or aggressive investing to continue so that, uniquely to this cycle, both lower quality and smaller companies are winning in a down year." Remarkably, he says, both speculative and small stocks that were overpriced on January 1 have beaten the blue chips year to date.
Because of his prescience in predicting the financial crisis, Grantham's views carry a lot of weight. Wealth manager Aaron Skloff, CEO of Skloff Financial Group in Berkeley Heights, N.J., disagrees, however. Skloff maintains Grantham is discounting "the positive impact a U.S recovery will have on smaller companies.
"Many smaller companies derive the majority of their revenue domestically," says Skloff. "Avoiding the meltdown of currencies around the world, including the euro, has enhanced their revenue recovery-particularly since the beginning of 2010. The U.S. is showing the greatest economic recovery of the three developed countries [the U.S., Europe and Japan], further enhancing the prospects for small-cap stocks.
"Furthermore," adds Skloff, "when banks resume lending to smaller companies that have been shut out of the financing loop, the smaller companies will be able to seize business opportunities that have been out of their grasp since the recession began."
Advisors such as Owen Murray, director of investment research at Horizon Advisors LLC, an RIA in Houston managing $150 million, also see more growth potential today in small caps than they do in large caps. "A problem we run into, however," says Murray, "is that small caps generally have limited capacity. So funds with good managers are typically closed to new investors."
Horizon Advisors uses the Baron Growth Fund, the Royce Pennsylvania Mutual Fund, the Royce Premier Service Fund, the Turner Emerging Growth Fund and the American Century Small Cap Value Fund in its clients' portfolios.
Truepoint Inc., an RIA in Cincinnati that manages $850 million, is keeping its powder dry in the small-cap space, according to Bradley A. Reed, a CFA and the senior manager of investment advisory services. "Since the small-cap space has performed well relative to the large-cap space recently, we have not been adding to our positions," says Reed.
Reed favors the DFA Targeted Value Fund, which he describes as "passively managed, but not a complete index fund." He also favors its sister vehicle, the DFA Small Cap Value Fund.
Year to date through July, the DFA Targeted Value Fund has returned 6.38%, while for the trailing 12 months it returned 27.14%.
Other advisors believe small-cap stocks are overvalued and have reduced their exposure in the sector. The Trust Company of the South, based in Burlington, N.C., cut back clients' positions in small-cap funds from 15% to 11% earlier this year, and may trim further, says Dan Tolomay, the chief investment officer.
Tolomay is looking for big caps to eventually outshine their smaller brethren. "If economic growth continues to be sluggish," he says, "the industry dominance of large caps should help them to grow earnings in challenging environments. Bigger firms are also more exposed to rapidly growing international markets."