The Trick to Small Caps

Video: Watch snippets of Chuck Royce and Irene Hoover's conversation.

To many investors, the risk premium associated with small-cap stocks is well deserved.

Small caps, after all, present investors special challenges. Liquidity, for one, can be limited when it comes to small companies, and this can create volatility in these stocks or, worse, make it difficult for an investor to sell a stock when buyers are scarce. Then, there's financial risk. Small companies tend to be more dependent on credit, so they can be hurt in tight lending environments. And there's business risk. With less-diversified revenue streams, small companies can be more vulnerable to economic cycles or some more-specific outcome, such as losing one big customer.

It's for these reasons, then, that small caps often fall earlier and harder in down markets--but then come out ahead in recoveries, at least at the onset, when optimism reigns. Morningstar's small-cap categories largely followed that pattern recently: Small-cap funds tended to perform worse between October 2007 and early March 2009. From March 2009 until the market's most-recent peak in mid-June, they outperformed overall.

But should investors paint all small caps with the same broad stroke, even now? Or can they work this perception of risk to their advantage?

To help us think about small caps, we brought together two experienced small-cap managers: Irene Hoover of Forward Small Cap Equity FFHAX and Chuck Royce, who manages a handful of Royce small-cap funds, including Royce Pennsylvania Mutual PENNX. Both have seen their share of bull and bear markets and economic cycles; Hoover started in the investment business in the late 1960s; Royce also has more than 45 years of investment experience. Our conversation took place May 28 at the 2009 Morningstar Investment Conference in Chicago. It has been edited for clarity and length.

Bridget Hughes: Are investors correct in believing that small-cap stocks come out of recessions much stronger than other parts of the market?

Irene Hoover: Traditionally, the small caps do come out stronger. They benefit from the closing of the credit spreads, because what has brought them down harder than the large caps is their inaccessibility to credit. Also helping them is their liquidity. Liquidity hurts them on the way down and helps them on the way back up. And finally, many of these companies are considered to be flaky or not very strong. But there are many good, sound companies in the small-cap universe, and at the bottom of a market, we are able to find great investments, which then begin to move up--even though in the beginning of the small-cap rally, the market is being driven by the really poor companies that are having a near-death experience and are being revived by the fact that they get credit. My view is that the small caps will continue to perform well.