With the pounding that small-cap stocks have taken in the last few months, you could be forgiven for thinking they've fallen completely out of favor with investors.
Not so, at least not among a group of fund managers with the flexibility to buy shares of companies of all sizes and who don't see the small-cap sell-off as a canary in the coal mine signaling something more dire in store for U.S. stocks, as was the case when small-company stocks fell ahead of the 2008 financial crisis.
Multi-cap funds, whose mandates allow them to invest in companies of any size, have been increasing their stakes in small companies as the Russell 2000 falls, according to data from fund tracker Lipper, a Thomson Reuters company. The average multi-cap fund now holds about 18 percent of its portfolio in small companies, a gain of one percentage point from the end of 2013 despite a 3 percent drop in the Russell 2000 since then.
Small-cap stocks are defined as those with market capitalizations of less than $3 billion.
Fund managers say that they see the sell-off, triggered by concerns that small-company stocks are expensive compared with those of larger companies and are poised to fall once the U.S. Federal Reserve ends its bond-buying stimulus program and interest rates rise, as a buying opportunity.
"In the small-cap carnage we've found many investments that to us look unduly penalized," said Connor Browne, a portfolio manager of the $1 billion Thornburg Value fund.
The fund increased the size of its small-cap holdings this year for the first time since 2011, Browne said. He said he has added companies such as Phibro Animal Health Corp, whose shares are up 31 percent since the company went public in April.
The steep selloff in small-company stocks has led some investors to worry that the end of the bull market that began in 2009 may be approaching. Larger companies are outperforming smaller ones this year after years of small-cap dominance. The Russell 2000 has doubled over the last five years, compared with an 89 percent gain in the S&P 500.
Yet there is little hard evidence that a drop in small caps portends a larger market decline.
Since 1980, larger companies performed better than smaller ones during the last six months of a bull market a little more than half the time, according to Sam Stovall, chief equity strategist at S&P/Capital IQ. So, as a signal, that's not much better than 50-50.
The decline in small-cap stocks is not a sign of a coming bear market, but a shift in investor behavior, Dan Greenhaus, an analyst at BTIG Research, wrote in a recent note to clients.
"We've seen a shift from lower quality stocks into higher quality stocks, higher beta into lower beta, and growth into value," he wrote, but not a shift away from stocks in general.
Even with the recent drop, small caps still look more expensive than larger ones. The Russell 2000 trades at a forward price-to-earnings ratio of 19.2, according to Birinyi Associates, compared with a P/E of 16.8 for the larger S&P 500.
Craig Hodges, a portfolio manager of the $545 million Hodges Fund, said that stretched valuations for small company stocks caused him cut his allocation to small-caps earlier this year to the lowest level in the history of his fund. But the selloff has prompted him to wade back in.
"On my shopping list are a bunch of small-cap names because that's where I'm seeing more opportunities in the short run," Hodges said.
He said he has recently purchased energy companies that have been hit by the drop in the price of oil and restaurant and apparel companies whose shares have fallen on concerns about declines in consumer spending.
Other fund managers are identifying small caps to buy should the market continue to drop.
Robert McIver, a portfolio manager of the $5.7 billion Jensen Quality Growth fund, said he has been looking at high-quality small-cap consumer and healthcare companies with strong balance sheets because he expects the broad stock market to continue to pull back over the last quarter of the year.
"I'm not a bear by any means, but we think investors need to be more discriminating," he said.
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