Two investors break down how to make money in small caps, one of the hottest trades of the year

  • Amy Zhang of Alger and Sandy Villere of Villere & Co. are portfolio managers invested in small-cap stocks that have outperformed their peers.
  • The Alger Small Cap Focus Fund Class A (AOFAX) has returned nearly 31 percent to investors and ranks in the first percentile of its category, according to data from Morningstar.
  • the Villere Balanced Fund (VILLX) has posted a return of 12.9 percent this year and ranks in the first percentile among balanced funds with 70-to-85 percent equity allocation.
Veeva Systems Founder and CEO Peter Gassner rings the opening bell at the New York Stock Exchange to celebrate the company's IPO on October 16, 2013 in New York City.
Source: Ben Hider | NYSE Euronext
Veeva Systems Founder and CEO Peter Gassner rings the opening bell at the New York Stock Exchange to celebrate the company's IPO on October 16, 2013 in New York City.

Small-cap stocks have been the place to be invested in this year relative to the large-cap names, and two investors seem to have cracked the code on them.

Amy Zhang of Alger and Sandy Villere of Villere & Co. are portfolio managers invested in small-cap stocks that have outperformed their peers. The Alger Small Cap Focus Fund Class A (AOFAX) has returned nearly 31 percent to investors and ranks in the first percentile of the “small growth” category, according to data from Morningstar. Meanwhile, the Villere Balanced Fund (VILLX) has posted a return of 12.9 percent this year and ranks in the first percentile among balanced funds with 70-to-85 percent equity allocation.

Their portfolios’ strong performances come as small caps have thoroughly outperformed the large-cap stocks. The Russell 2000 index is up about 11 percent this year and hit a record high on July 10 while the S&P 500 is up just under 5 percent in 2018.

However, not many people think of investing in the smaller stocks since they are not as popular and are not talked about nearly as much as the larger companies. Small caps also tend to be more volatile than large-cap stocks given their size. CNBC talked to Zhang and Villere about how they pick stocks and their investment process.

Zhang said she tries to find companies “that have a competitive advantage over their peers,” can disrupt industries “but are also sustainable,” and have strong financials.

One example of such a company is Guidewire Software, a company that makes software for insurance companies, Zhang said. Guidewire can benefit as the insurance industry is in the “early phase of reducing costs and improving revenue by replacing antiquated [information technology] infrastructure. The addressable market is very large, close to $8 billion, with very low penetration today,” she said.

Guidewire also generates lots of cash and invests heavily on research and development “to stay at the cutting edge of innovation.” Shares of Guidewire are up more than 25 percent this year.

Zhang also highlighted Veeva Systems, a cloud-computing company that caters to pharmaceuticals, noting it “exemplifies what we look for in a company.” She said the company has a wide moat, or competitive advantage, and 20 percent annual revenue growth.

Veeva shares are up more than 50 percent in 2018 and Zhang said the stock has more room to run. “The addressable market is very large, close to $8 billion, with very low penetration today,” she said.

Guidewire and Veeva are two of the largest holdings in Zhang’s fund, with respective portfolio weights of 3.78 percent and 2.56 percent, Morningstar data shows.

Zhang has managed the AOFAX fund since February 2015. The four-star rated fund has $1.6 billion in assets under management and has returned nearly 19 percent over the past three years. The fund is also in the fourth percentile in its category over that time period.

Searching for hidden gems

Villere of Villere & Co. said he looks for stocks with price-to-earnings ratios that are lower than their growth rate. But to find such companies, Villere says he hunts for stocks that are not widely covered by Wall Street.

“To invest in these great businesses, … we need to find these companies when they are younger and therefore smaller so that Wall Street hasn’t yet discovered them,” he said.

One such company is Ebix, a firm that supplies software services to insurance and financial companies. "We anticipate over time as the company continues to perform, larger bulge bracket firms will discover the company and write on them. The increased visibility can result in more investors discovering them which can lead to higher valuations," Villere said.

Villere also said he tries to find companies with attractive valuations relative to their peers. An example is Cypress Semiconductor, a chipmaker that makes supplies for the several "internet of things" products, including the Amazon Echo. The stock is up more than 12 percent year to date and has a price-to-earnings ratio of about 14, below an average multiple of 19 for its peers, Villere said.

“It’s cheap as dirt,” Villere said. “We only own 23 stocks in our portfolio, so we’re always looking for those pockets of cheap stocks.”

Villere also likes 3D Systems, a 3D printing company. While the company sells 3D printers at a low margin, “they just gobble up the materials and sell them at a really high margin,” he said.

The company also supplies Align Technology, the company responsible for creating Invisalign, a clear teeth aligner. “Without this company, Align Technology would not exist,” said Villere. Shares of 3D Systems are up nearly 80 percent year to date.

Villere has managed the Villere Balanced Fund since September 1999. The fund has a three-star rating at Morningstar and has $296.9 million in assets under management. Over the past 10 years, the fund has returned nearly 10 percent to investors and ranks in the first percentile of among balanced funds with 70-to-85 percent equity allocation, according to Morningstar.

Small-cap stocks have benefited this year from more favorable valuations compared to large caps, lower taxes and rising trade tensions between the U.S. and some of the largest economies in the world.

“It seems like everything is working in favor of small caps,” said Villere. “Even the trade war fears seem to be working in their favor.”

Small caps have lower overseas revenue exposure than large-cap companies, which typically do lots of business outside of the U.S.

Zhang of Alger said small caps have more room to run, as they are still below their historical enterprise value to sales ratio. She also said: “I do think it’s small caps turn because they have historically outperformed the large caps, but in recent years they have lagged.”