Can Small Caps Continue Their Run?

John Coumarianos: Charlie, I wanted to ask you one more question about the markets in general, something we talked about earlier this morning in our meetings.

I know you're a bottoms-up, fundamental-oriented stock-picker, and you don't base most of your decisions on a macroeconomic outlook. But one can't help but notice, when one looks at the markets for the past decade, that although the S&P 500 has declined, cumulatively, 10%, from the beginning of 2000 through a couple of days ago, the Russell 2000 Index has actually gone up 40%, and the Russell 2000 Value Index has gone up over 120%, I think, over that period of time.

Your fund, of course, has outperformed them all, with a 200% cumulative return. But it begs the question... this has been the small-cap decade, it appears--whether small caps can continue to go on this run, especially relative to large caps.

Charles Dreifus: Well, I have my doubts whether small caps as an asset class can continue this. There's usually a cycle, and I am a bottom-up person, but the macro picture seems to suggest that companies that can generate consistent, organic growth, that are multinational, are probably going to benefit a bit more in the years ahead. Clearly, most small caps are not multinational, and it's probably more difficult to find reasonably priced, in any event, organic growers in the small-cap area.

So, if I were to have to say to someone, if you're going to choose an index fund, you want to participate in the U.S. market, I would advise them to not do a small-cap index fund, and perhaps do a large-cap, and perhaps even further a large-cap growth index fund, for the years ahead.

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Having said that, I think there is a place for the active small-cap manager. I think, hopefully, if I can include myself in that category, there are ways about going about investing that, even when you have headwinds, you can still produce excess returns. And that's by being very mindful of price, seeking those attributes. Would I like to have companies that have organic growth? For sure. But mostly, they're too expensive.

Now, my companies, I believe, as an example, will benefit, even in an environment where small caps as a class might not. What I'm thinking of here, and we're seeing some evidence of it already; one of my holdings, only yesterday, got a takeover bid, is that because it's going to be more difficult to grow, and therefore favoring the organic ones, companies that don't have that organic capability are going to grow by acquisition. And because of my being so mindful of valuation and those financial attributes, the pristine balance sheets, my companies could likely be targets.

Coumarianos: Your companies have a lot of the characteristics that private equity firms look for.

Dreifus: Private equity firms or strategic buyers, in terms of consolidating an industry. The majority of the companies in my portfolio that have been acquired over the last two and a half years, ratio of roughly two-thirds to one-third: two-thirds of the companies have been acquired by strategic buyers.

I think that's going to pick up momentum. And I think also contributing to that is the fact that a lot of small companies, including the ones in my portfolio, have a dominant family that might own 20, 30, 40%.

It seems almost a given that, within a year or two, we're going to have much higher income-tax rates on capital gains and dividends, that those families and those companies will be giving serious consideration of doing some kind of transactional event, whether it's going private, selling to a private equity group, selling out to a strategic buyer who's consolidating, doing a Dutch tender, paying a one-time special dividend.

But in any event, it will be value-creating. And I think that, in the nearer term, meaning the next year or two, could certainly give some small-cap portfolios performance that will seem attractive.

Coumarianos: Sure. So your companies still have good potential, it sounds like. But it also seems to make sense that investors should diversify by owning a good large-cap fund as well.

Dreifus: I've always told people that, in any asset class, you do not want to overdo it. And what people often don't do enough of is rebalancing. And to the extent that small caps have been on a tear, I mean, this sounds sort of contrary to my and our interests, but realistically, the same as the caution that I use in stock-picking, caution for someone in their own portfolio is to be mindful of concentrations that build up.

Coumarianos: Well, Charlie, we couldn't have put it any better ourselves at Morningstar. Thank you so much for joining us today.

Dreifus: Thank you so much for inviting me and being here at our offices.

Coumarianos: You're welcome. This is John Coumarianos for Morningstar signing off. Thanks very much.