I'm not a big believer in "style-box" investing - that is, the practice of dividing up your portfolio into pre-determined portions of certain types of stocks, such as large-cap value or mid-cap growth. To me, the best approach for individual investors is to look for the best values in the market, wherever they may be. Sometimes, that may mean your portfolio is carrying a good number of large-cap value stocks; other times, it may be more focused on small-cap growth firms.
I am, however, a big believer in using long-term historical data to guide investment decisions. And it's hard to ignore the data showing that, over the long haul, small-cap value stocks are a great place to look for investment ideas.
From 1927 through 2009, U.S. large-cap growth stocks have averaged a 9.08-per-cent annual compound return, according to the data of Dartmouth College professor and noted stock researcher Kenneth French. Small-cap growth stocks, meanwhile, have averaged 9.23 per cent, and large-cap value plays have fared even better, averaging 11.21 per cent. But well ahead of the pack are small-cap value picks, which have averaged a 14.17-per-cent return per year. (For the breakpoint between small and large stocks, Prof. French and colleague Eugene Fama use the mean market equity of New York Stock Exchange stocks. Growth stocks are defined as those in the bottom 30 per cent of the market based on book/market ratios; value stocks are those in the top 30 per cent.)
Is this just happenstance? Most likely not. There are a number of advantages that small-cap value plays have. Smaller companies, for example, just have more room to grow. Once a company gets to a certain size, it's not going to be putting up the huge growth numbers that smaller upstarts are putting up. And smaller companies are often more nimble and able to adjust to shifting conditions than are larger firms.
Another big advantage is that small stocks in general aren't as well known as their larger peers. That means they fly under the radar, getting less coverage from analysts and less attention from mutual funds. As mutual fund great Peter Lynch noted, funds often have rules in place preventing them from buying stocks with market caps below a certain threshold. That often means they can't buy small companies' shares until the stock's price - and thereby its market cap - has risen, and they are no longer great bargains.
Because of their under-the-radar status, smaller stocks tend to be more susceptible to mis-pricings that smart investors can take advantage of. And, if a small stock is getting a lot of attention, it's likely that it's a fast-growing firm, not a bargain-priced value pick. That's another plus for small-cap value plays.
A lot of the gurus upon whom I base my Guru Strategies recognized the benefits of small stocks - even those who can no longer focus on them, like Warren Buffett. Because of its huge size, his Berkshire Hathaway can't buy enough shares of a very small stock to really make an impact on Berkshire's overall returns in a big way. But at Berkshire's 2008 shareholders meeting, Mr. Buffett said he would think much differently if managing only a few million dollars. That, he said, would open up thousands of opportunities, mostly in small stocks and specialized bonds.
All of this doesn't mean that investors should focus only on small-cap value stocks. As I said earlier, I believe in going after the best values in the market, regardless of where they are. But what it does mean is that when searching for bargains, you should make sure that you don't do what much of Wall Street does - ignore the unloved little guys.
Flying under the radar
John Reese recently used his Guru Strategies to search for some of the most fundamentally sound small-cap value picks (companies with market caps below $1-billion and price-to-book ratios of 1.0 or lower). Here he describes three that caught his models' eyes.
Synnex Corp. : Based in California, Synnex provides a variety of information technology and business services, and operates in the U.S., Canada, and parts of Latin America and Asia. While it's a small-cap worth $896-million (U.S.), Synnex has taken in more than $8-billion in sales in the past year. It gets high marks from my Lynch-based model, which likes the company's 15.9-per-cent long-term earnings-per-share growth rate (I use an average of the three-, four-, and five-year earnings-per-share growth rates to determine a long-term rate). The model also likes that Synnex's price-to-earnings ratio divided by its growth rate (its P/E/G ratio) is just 0.57 - a sign the stock is a bargain - and that it has a manageable 31.8 per cent debt-to-equity ratio.
Apogee Enterprises : This Minnesota-based firm ($300-million market cap) makes glass and acrylic products used in construction, picture frames, and commercial optics. It has struggled since I wrote about it back in January, amid a rough period for commercial construction, but my Benjamin Graham-based model thinks that's made for a good opportunity to get shares of a strong business on the cheap. It likes Apogee's strong balance sheet - the company has a current ratio of 2.05 and almost six times as much net current assets as long-term debt. Apogee, which has taken in more than $650-million in sales in the past year, also sells for just 0.89 times book value, another reason my Graham-based model likes it. Disclosure: I'm long APOG.
AAR Corp. : Based in Illinois, this aerospace and defence industry small-cap ($646-million) is another favourite of my Lynch-based model. It likes the firm's impressive 43.3-per-cent long-term EPS growth rate, and its excellent 0.28 P/E/G. AAR's debt-to-equity ratio is also a manageable 44.5 per cent, and it sells for just 0.88 times book value.