It Looks Like Prime Time for Small-Cap Stocks

When the economy is weak and the upside for equities is limited, investors typically turn to smaller companies for growth. That dynamic is repeating itself now, as small-cap stocks surge past the sluggish broad market.

The small-cap Russell 2000 index, which includes firms with an average market cap of $530 million, was up 9.12% through the third quarter. The Russell Micro Cap index, which includes companies with a market cap of up to around $300 million, gained 7.94% over the same period. In contrast, the Standard & Poor's 500, the benchmark for the broad market, has chugged along at a modest 3.89%.

That doesn't surprise Jack Fockler, managing director with Royce & Associates in New York. The $32 billion asset management company has focused on small-cap investing since Chuck Royce founded it in 1972. "Historically, smaller companies have done significantly better during low-return periods," Fockler says.

"Fertile Ground"

The small-cap stock world includes high-quality companies in a range of sectors such as construction and manufacturing according to Fockler. The segment has its share of risk, though. Volatility tends to be high, and the incidence of fraud among so-called penny stocks is a well-known problem.

However, a focus on fundamental, bottom-up analysis can identify smaller companies that are as sound as much larger, well-known institutions such as General Electric (GE) and offer attractive returns, according to Fockler. "The industrial sector has been and remains a fertile ground for micro-cap investment. We're able to find lots of companies that possess excellent balance sheets, generate above-average returns on capital and that are trading below our estimate of their worth as businesses," Fockler says.

Take Lamprell (LMPRF), which is Royce's top holding, accounting for 1.5% of its portfolio. It's a 30-year-old oil-and-gas rig-construction company based on the Isle of Man and with operations in the Middle East. The stock has returned 72% over the last year.

Fronteer Gold (FRG), a mining company based in Vancouver, B.C., also is indicative of the kinds of companies Royce is drawn to. Fronteer, Royce's No. 2 holding accounting for 1.2% of assets, has gained 59.74% over the last 52 weeks. The S&P 500 has gained 8.14% over the same period. Another example: OYO Geospace (OYOG), a company in Houston that makes instruments for measuring seismic change, is up 145% over the last 52 weeks. It accounts for 1% of Royce's portfolio. The S&P 500 has gained 8.14% over the same period.

Not Necessarily Cheap

Still, some areas are too volatile even for Royce. Fockler says he's avoiding small-cap financial companies at the moment because of their balance-sheet problems.

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Smaller stocks are a challenge for investors, and institutions tend to avoid them. Investing in this zone is still dominated by individuals, according to Fockler. While opportunity exists in this end of the market, these stocks aren't necessarily cheap. Lamprell and Fronteer both have price-earnings ratios in the 30s. He says the trick is to find smaller companies with sound businesses and carefully make their volatility work in your favor.

Royce accumulates its positions in companies incrementally, over long periods of time. The firm tends to move in opposite directions of the market, buying when others are selling, and vice versa. It also protects itself from individual company volatility by broadly diversifying its holdings. The $1.2 billion Micro Cap fund -- up 11% year-to-date-has positions in 200 companies.

"The investment opportunity is not broad-based per se. In other words, I can't say that small- or even micro-cap companies are cheap relative to their large-cap counterparts," says Fockler. "Within each respective universe, the opportunity is much more stock-specific. But in general, the quality segment of both universes is especially attractive."