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Small-Caps Ready to Lead As Global Markets Remain Volatile

Smaller companies continue to outperform this year, providing investors a potentially safer place to stay as the stock market endures global turbulence.

New York Stock Exchange Traders
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New York Stock Exchange Traders

As the market has rallied sharply off the March 2009 lows and continues in positive territory this year, small-caps have provided much better value as the group has been able to shield itself from trouble abroad and pressures from a rising dollar. Small caps generally refer to companies whose stock market value is $2 billion or less.

The Russell 2000has gained about 11.2 percent in 2010, compared to Standard & Poor's 500 gains of about 3.65 percent. Small-caps have slightly underperformed the S&P and Dow during May's market seesaw, but continue to find strong support among investors.

"Part of the reason for that in recent market action is the idea that these companies will be able to bounce back more quickly in terms of generating earnings and getting those results to the bottom line," says Richard Sparks, senior analyst at Schaeffer's Investment Research in Cincinnati. "Those companies that continue to grow at multiples that are going to be much more than their big-cap peers will more than likely continue to be rewarded."

While the Standard & Poor's 500 has gained about 73 percent over the past 14 months since the March 2009 market lows, the Russell 2000 has more than doubled.

Leading sectors have been consumer discretionary, financials and materials, the latter of which has been one of the weakest sectors on the S&P.

Going forward, though, investors will want to focus on value rather than growth as markets get riskier, says Lawrence Creatura, portfolio manager at Federated Clover Capital Advisors in Rochester, N.Y.

"It's superior from a risk perspective and it's got a lot less risk than the growth side of the equation," says Creatura, who runs the Federated Clover Small Value Fund, with total assets of $145 million. The fund is up 13.7 percent in 2010, easily outpacing the S&P, and is a three-star fund with Morningstar.

"Small-cap value specifically is a superior asset class that virtually every equity investor should have an allocation to. They are structurally superior," he says.

One benefit Creatura touts is the fluidity of the Russell 2000 compared to other major indexes that tend to be more static in what stocks compose them. The Russell does a rebalancing every year—the next one happens in June—that helps protect the index from less-worthy stocks.

By comparison, the Dow changes components on a more arbitrary basis. During down times, such as the financial crisis, the Dow can be weighted with stocks that are less than bluechip in nature.

"The small-value universe is reborn every year during the Russell reconstitution when all the small stocks and cheap stocks are swept into the Russell 2000 value benchmark, reinvigorating it," Creatura says. "That pool of great stocks with special characteristics is recharged every June."

To be sure, small-caps face obstacles and are not bullet-proof.

While financials have been a leadership group and are advocated as a growth area by Creatura, the group's first-quarter earnings were not as impressive as large-cap banks.

About 78 percent of large-cap banks beat estimates while only 16 percent missed; by contrast 53 percent of small-cap banks beat and 38 percent missed, according to Keefe, Bruyette & Woods.

And the May roller-coaster has been a bit harder on the Russell than the other indexes.

"If the market were to continue to weaken, even though those (small-cap) companies may end up continuing to produce good earnings the stocks themselves could suffer," Schaeffer's Sparks says. "We would definitely see those stocks tend to be more volatile."

Conversely, strength in the dollar brought on by global turbulence could help small-caps.

Conventional wisdom is that smaller companies do more of their business domestically and therefore don't have to rely on cheap currency to drive their business. It's not a universally held belief, but is one of many factors that can drive investor interest in the group.

"If everything comes under pressure, whether small does better depends on external factors," says Tim Holland, co-portfolio manager of the Aston/TAMRO Small Cap Fund, a four-star $982 million fund that is up 11.1 percent this year.

Holland advises investors to stick with buy-the-dip strategies as the market gyrates. He sees consumer stocks, financials and information technology as leaders.

"We still see more ideas than we have capital," he says. "From a fundamental perspective, we see great opportunity (in small-caps) which makes us more optimistic about the market as a whole."

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