Eugene Fama's research on asset prices has earned the finance professor a long-overdue Nobel Prize in economics. Many investors and financial advisers are also familiar with his work on how small-cap value stocks have outperformed the broader market over the long haul.
But investors who want to capture the small-cap value premium should be prepared for some twists and turns, as many of these companies have fallen out of favor with Wall Street. Of course, risk can spell opportunity, especially if investors can live with some volatility.
Spencer Grimes, investment manager at Connecticut-based registered investment adviser Twinleaf Management, takes an active approach to small-cap value stocks. He says "a strong stomach is advisable" for investors in the asset class. Grimes manages the Small Cap Value strategy on Covestor, a portfolio of stocks mostly in the tech, media and telecom (TMT) sectors.
He hunts for undervalued stocks that have the potential for significant capital appreciation, including companies that could be acquired. He typically invests in stocks that have a market capitalization of $3 billion or less.
Small-cap stocks tend to outperform their larger peers over longer time periods but are also potentially more volatile. Within the U.S. small-cap universe, value stocks have historically done better than growth. For example, small-value stocks with low price-to-book ratios have outpaced their growth counterparts by 6 percentage points annualized, from 1927 through 2012.*
Grimes, a former Wall Street analyst and private equity investor, runs a concentrated portfolio of small-cap value stocks, typically between 8 and 12 names. He focuses on identifying misunderstood, out-of-favor companies, which draws on his experience in the private equity world.
“Due to the dearth of Wall Street research coverage and many fewer fund managers with a focus on the category, small caps offer compelling investment opportunity for those willing and able to dig in the trenches for overlooked or misunderstood names," he said.
Grimes keeps a close eye on over 100 potential stocks and works up valuations models for every company on his radar screen. His due diligence often includes meeting with company management.
He acknowledges that small-cap stocks tend to be more volatile due principally to three factors — less trading liquidity in the stocks, less information in the marketplace and less professional management.
It's not uncommon for investors in small-cap value names to get blindsided by an earnings miss, and the relatively illiquid stocks can drop sharply when large institutional investors exit a position. However, these stocks can see equally large jumps, such as when a company successfully executes a turnaround, a firm is bought, or when bearish investors get caught in a short squeeze.
Grimes said he goes well beyond seeking small-cap value stocks that are trading below fair value, because that threshold is easily met. Small-cap value shares often have low valuations because their business models involve greater risks, profitability is low or the companies are distressed.
"I look for companies that have a catalyst in place that will force the market to recognize the hidden value and eliminate the trading discount to fair value," the portfolio manager said. "Often, that is an M&A event, but not always. I have several portfolio companies executing turnarounds or ramping growth with a new product or new management. I also look for balance sheet cash to serve as a downside buffer, and sometimes you can even find small caps trading near cash value."
All opinions included in this material are as of October 18, 2013 and are subject to change. The opinions and views expressed above are of the portfolio manager and may differ from other managers, or the firm as a whole. Investment involves risk. Past performance is no guarantee of future results.
*Source: Morningstar analyst report on iShares Russell 2000 Value ETF.
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