RIAs Ride Small-Cap Wave at Home and Abroad

Despite their volatility, small-cap stocks can help registered investment advisers to tap into local economies and boost portfolio growth.

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For many investors, 2016 got off to a rocky start, with the sell-off that started last summer extending into February. Small-cap stocks were one of the few bright spots. After largely underwhelming performance for the past couple of years, U.S. small-cap funds used the drawdown to load up on cheap equities and ride them through the rally that started in March. That’s made the asset class one of the top performers in recent weeks.

Cycles like this, in which small-caps outperform in challenging conditions, show why they’re a core part of institutional portfolios, but are they right for individual investors? In a volatile and low-growth market, wealth managers may want to take a closer look.

Neumeier Poma Investment Counsel, a $635 million registered investment adviser based in Carmel-by-the-Sea, California, deals exclusively in small-cap stocks. “The sell-off created a lot of opportunities for us in terms of adding to our positions,” says partner and portfolio manager Brian Poma. In many cases, investors were selling as part of a macroeconomic panic and not because of fundamentals, Poma contends.

According to regulatory filings, Neumeier Poma has a wide-ranging U.S. small-cap portfolio that includes names like St. Louis–headquartered retailer Build-A-Bear Workshop and Kenosha, Wisconsin–based toolmaker Snap-on. Last year the firm’s small-cap strategy gained 5.61 percent, versus 2.88 percent for its benchmark, the Russell 2000 index.

Poma’s call that the sell-off wasn’t driven by fundamentals turned out to be right: U.S. small-cap funds have largely turned positive for the year, whereas other asset classes remain flat. The S&P SmallCap 600 index is up from its February low, too, by 19.4 percent through April 29, versus 14.1 percent for the S&P 500. The S&P SmallCap 600 is also handily beating its performance for the first four months of 2015, when it was down about 1.8 percent.

The rest of the world is paying attention. In a recent global survey of 100 investment managers by Chicago-based Northern Trust Corp., respondents were bullish on U.S. small-cap stocks as an asset class, ranking them third in 14 categories for the first quarter of 2016, one notch above U.S. large-cap equities.

Still, small-cap stocks are known for being highly volatile, even when there isn’t a major sell-off. That unpredictability and concerns about other risks, like poor governance or investing in young, untested companies, have kept more conservative retail investors away. Meanwhile, thin analyst coverage of small companies makes it tough for wealth managers to gather information beyond the pitches they get from small-cap funds.

But David Adams, Boston-based principal and co–portfolio manager for small- and midcap at Aristotle Capital Management, thinks those worries may go too far. “The risk in small-cap is probably overstated,” explains Adams, whose Los Angeles–based RIA manages $11 billion in assets. “Not all of these companies are mom-and-pops. Many are well established.” Aristotle owns several such stocks, including Atlanta-based children’s clothing maker Carter’s and delivery service 1-800-Flowers.Com, headquartered in Carle Place, New York.

The U.S. small-cap market has consolidated over the past few years as performance waned, Adams says. Many of the riskier names folded, leaving those companies that were strong enough to weather the recent rough patch.

Small-cap companies can offer other benefits. More often than not, they’re tied to local economies, have relatively simple business models and lack the big asset flow swings that come from being included in several exchange-traded funds, as many large-cap stocks are.

“You’re investing in a local store or a local industrial operation, and often local economies are much more stable,” says Reid Galas, portfolio manager of the international small-cap strategy at Boston-based, $22.8 billion GW&K Investment Management. “Walmart’s size, for example, means they’re only going to do as well as the retail sector as a whole.”

In Galas’s view, global exposure to small-cap stocks can benefit all types of portfolios in a low-growth environment. Right now, he’s focused on Japan. Galas argues that although many investors view the country as an exporter — and one plagued by a sluggish economy — the small-cap story is more internal. He’s overweight Japanese small-cap consumer companies that have steady local demand. Consumer names drive much of Galas’s international small-cap universe, which comprises equities from 21 other countries, including Australia, Canada, China and Israel.

“Small-cap can be a way to get what you actually want from global exposure,” he contends. Many investors who allocate globally get tied up in emerging-markets debt or utilities or parts of the export economy, all of which are much more sensitive to changes in the market, Galas adds. “If you’re investing in a local company, the local consumer is always going to be there,” he says. “You’re investing in the middle class.”

When it comes to investing in the U.S., managers like Michael Thomas, senior portfolio manager at $1 billion, San Francisco–based Falcon Point Capital, have taken a shine to the deep-value opportunities that have emerged in small-cap U.S. tech stocks. In that category, Thomas says there’s a strong growth story for business services outfits like WageWorks, which provides employee health benefits services. Falcon Point holds the New York–based company, whose stock closed at $53.86 on April 29, up 18.7 percent for the year. Small-cap industrials also rebounded in March and April as worries about a U.S. recession diminished, Thomas notes.

For investors who need growth, small-caps can be a consistent source, GW&K’s Galas says. “I think investors are struggling with where to find yield, and we’re all going to have to think about asset management differently going forward,” he observes. “Small-cap names can be one of the growth drivers in a portfolio, if done well.”

Aristotle’s Adams agrees. The key lesson for wealth managers is that small-caps can be uncorrelated to macroeconomic trends, leading to good performance even when other parts of the market are down, he explains. That can be a boon for portfolios in a rocky market. “We think that small-cap should be part of the core equities holding,” Adams says. “We take a long-term view in terms of how we trade these stocks.”

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