An Opportunity to Get Small

A version of this article first appeared in the August 2019 issue of Morningstar FundInvestor. Download a complimentary copy of FundInvestor by visiting the website.

The small-cap premium has been a penalty of late, and therein may lie opportunity. Shares of big companies, like Microsoft MSFT, have outpaced those of small companies by quite a bit in recent years. So pronounced was this trend over the past year through June 2019 that the mega-cap Russell Top 200 Index's 10.9% return beat the small-cap Russell 2000 Index by 14.2 percentage points. Apart from between October 2013 and November 2014, that is the Russell Top 200's biggest one-year edge over the Russell 2000 since the late 1990s. The difference between now and that 2013-14 time period, however, is that in 2013-14, mega-cap companies' trailing 12-month earnings on average traded at a 13% to 17% discount to small-cap companies' earnings, whereas now those earnings cost about 16% more. Buying small caps may once again reward long-term investors more handsomely than mega-caps if history repeats, something that's still the case over the past two decades.

Those wishing to bargain-hunt in small caps have four excellent options to consider here. Each strategy receives a Morningstar Analyst Rating of Gold and is open to new investors.

Vanguard Tax-Managed Small Cap VTMSX tracks the S&P SmallCap 600 Index while minimizing tax consequences, including realizing capital losses to offset unavoidable capital gains. The strategy has a quality orientation relative to the Russell 2000 Index because the committee in charge of selecting the S&P SmallCap 600's constituents avoids recent IPOs and only considers adding profitable stocks.

DFA US Small Cap's DFSTX screens go further. They exclude the least profitable and most expensive names (as well as REITs) from its universe of the smallest 10% of U.S. stocks. The portfolio managers market-cap-weight the remaining stocks and use a flexible trading approach to reduce transaction costs. The firm also acts as a liquidity provider in thinly traded stocks, allowing it to secure more favorable prices. Long-term performance is strong, but the fund can lag for long periods.

Veteran portfolio manager Sudhir Nanda works as part of the 18-person team running T. Rowe Price QM U.S. Small-Cap Growth Equity PRDSX. The strategy's quantitative model values most companies on cash flow, assigning a 40% to 45% valuation weighting. Earnings quality, profitability, and capital allocation account for 30% to 35% of the model, and price momentum rounds out the rest. Nanda and his team build a roughly 300-stock portfolio, keeping sector bets to a minimum relative to the MSCI US Small Cap Growth Index. That has translated into outstanding performance versus the benchmark and within the small-growth Morningstar Category since Nanda's October 2006 start date.

FMI Common Stock FMIMX has been in the mid-cap blend category since March 2002, but it routinely has one of the category's smaller average market caps. As of June 2019, nearly 30% of the equity portfolio was in small-cap stocks. Its 10-person management team includes CIO Patrick English and research director Jonathan Bloom, who vet each member's investment ideas. Focused on stocks with market caps below $5 billion, they look for profitable businesses that are trading at a minimum one-third discount to their estimated intrinsic worth in a five-year holding period. Such bargains tend to occur because of controversy or uncertainty. The team trims or sells stocks as they become fully valued, not just because they've crossed a certain market-cap threshold. FMI keeps tabs on liquidity in the fund's 35-stock portfolio and doesn't hesitate to close it to preserve flexibility. Indeed, prior to reopening in mid-2016, the fund had been closed to new investors since year-end 2009. While the fund's value orientation has been a headwind in the postcrisis market environment, its record over the past 15 years remains excellent.