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This quality approach to a cheap part of the stock market garners a five-star rating

By Philip van Doorn

Small-cap stocks are trading at the bottom of their valuation range over the past two decades

Large-cap stocks dominate financial media coverage, and rightly so - but they also drive warnings that the S&P 500, which is heavily weighted to its largest components, is overvalued.

According to Steve Scruggs, portfolio manager of the $688 million FPA Queens Road Small Cap Value Fund QRSVX, small-cap stocks as a group are trading at their lowest level relative to large-cap stocks, and "especially large-cap growth" stocks, "since the peak of the internet bubble."

Scruggs is based in Charlotte, N.C., and has managed the FPA Queens Road Small Cap Value Fund since it was established in 2002. The fund is rated five stars (the highest rating) within Morningstar's "Small Value" fund category. Its investor share class has had a three-year return, net of expenses (0.96% of assets under management annually), of 12.7%, compared with a 3.1% return for its benchmark, the Russell 2000 Value Index XX:RUJ. The fund's advisor share class has lower expenses of 0.90% of assets, and its institutional share class has an expense ratio of 0.79%.

During an interview with MarketWatch, Scruggs described his "bias toward quality" and talked about four of the fund's stock holdings.

Testing the notion that small-cap stocks are relatively inexpensive right now

Of course, a small-cap manager would say that the asset class he focuses on is attractive. So let's test broad valuations to see how they look, leaving aside the difference between growth and value stocks.

Investors are likely to look at the Russell 2000 Index RUT if they want to look at small-cap stocks as a group. But this index isn't selective - it includes hundreds of companies that aren't profitable. The S&P Small Cap 600 Index SML has criteria for initial inclusion that include four quarters of consecutive profits. So this will make for a less extreme comparison of price-to-earnings valuations with the large-cap S&P 500 SPX.

The dot-com bubble in the stock market peaked in March 2000. We can go back to the end of January 2000 to compare valuations of the two indexes. First, here is a chart showing how forward price-to-earnings ratios for the indexes have moved since then:

The S&P Small Cap 600 Index is trading a bit below its average forward price-to-earnings ratio of 14.7 since the end of January 2000. The S&P 500's forward P/E ratio is 20.8, compared with an average of 16.5 from the end of January 2000.

Now take a look at the rolling forward P/E ratio for the S&P Small Cap 600 Index against the large-cap U.S. benchmark:

The S&P 600 Index is trading at a forward P/E that is 0.69 times that of the S&P 500. This is close to its cheapest valuation, by this measure, since the end of January 2000.

One more thing to consider if you are worried about large-cap stock valuations is the S&P 500's concentration: It is weighted by market capitalization. This means that the top five components of the SPDR S&P 500 ETF Trust SPY - Microsoft Corp. (MSFT), Apple Inc. (AAPL), Nvidia Corp. (NVDA), Inc. (AMZN) and Meta Platforms Inc. (META) - make up 24% of the portfolio. SPY is designed to mirror the performance of the S&P 500; the top 10 companies held by SPY comprise 34% of the portfolio.

Focusing on quality in the small-cap space

The FPA Queens Road Small Cap Value Fund held 50 stocks at the end of 2023.

"Our portfolio is generally about 80% quality, long-term compounders - companies that we will be happy to hold forever if things go the way we expect," Scruggs said.

The remaining 20% of the stocks in the portfolio are those of companies that are attractively priced, according to Scruggs, because of specific events within industries or with the companies themselves. "They are not of the highest quality right now, but what is needed to get the companies in the right direction is identifiable and measurable," he said.

Scruggs described "four pillars" of analysis he uses to select stocks, "which quite frankly everybody looks at:"

Balance-sheet strength: Companies with higher levels of debt tend to have more volatile earnings, Scruggs said. A low level of debt "gives downside protection," he added.Valuation: Scruggs and colleagues use discounted-cash-flow valuation models to arrive at "reasonable" valuations, with a margin of safety.Management: Scruggs said that he likes management teams to lay out specific strategies and stick with them. "We do not care about hitting quarterly numbers," he said. He also wants compensation plans for executives to encourage "long-term thinking."Sector and industry analysis: One problem with selecting value stocks (generally those of mature companies that trade relatively low to book value or earnings, which can include high dividend payers) is that an investor can fall into a "value trap." A stock might be cheap for a good reason, especially if the company is in a declining industry. Industry analysis can help to avoid value traps, Scruggs said. "Over the years, most of the mistakes I have identified have been value traps. A company may have been cheaply priced, but was a melting ice cube," he said.

Examples of stocks held by the fund


Regional banks have been in the news quite a bit over the past year, with specific problems leading to the failures of three larger players. One smaller industry name that Scruggs holds in the fund's portfolio is ServisFirst Bancshares Inc. (SFBS) of Birmingham, Ala.

The bank has about $12 billion in total assets, with only 22 branches. Scruggs credits that "branch-light" business model with helping ServisFirst typically achieve low efficiency ratios. In the banking industry, the efficiency ratio is expenses divided by revenue; lower is better, and a ratio below 50% is typically considered to be good. Over the past five reported quarters, ServisFirst's efficiency ratio was below 40%.

"They were quick to go digital, Scruggs said. He also said that after regional banks sold off last year, he added to this position.


Fabrinet (FN) is a contract manufacturer for optical communications equipment and components. This type of manufacturing is "generally not an area where you think of pricing power and dynamic business models," Scruggs said, but things have worked out well for Fabrinet because "their data-center businesses is booming."

According Scruggs, "Nvidia became a 10% customer for them" last year.

The FPA Queens Road Small Cap Value Fund initially purchased shares of Fabrinet in 2014. With the stock performing so well over the years, Scruggs has continually trimmed the position. But he said he still thinks the stock is attractively priced for new investors.

Shares of Fabrinet now trade at a forward P/E of 21.3. Based on calendar-year consensus estimates among analysts polled by FactSet, the expected compound annual growth rate (CAGR) for the company's sales form 2023 through 2025 is 10.8%, with an expected EPS CAGR of 11.3%. This compares with expected weighted sales CAGR of 3.5% for the S&P Small Cap 600 over the next two years, and an expected EPS CAGR of 8.1% for that index. For the S&P 500, the two-year sales CAGR is expected to be 5.8%, with an expected EPS CAGR of 12.4%.


The FPA Queens Road Small Cap Value Fund has held shares of Graco Inc. (GGG) since 2002, with the size of the position ranging according to the stock's valuation, Scruggs said.

Graco makes fluid-handling equipment, such as sprayers and pumps. "They have never gone through an reorganization or made a large acquisition" since 2002, he said. And he sees this company as a play on the long-term growth of the U.S. economy, describing it as "kind of a GDP-growth-plus" business.

Right now Graco is trading at a relatively high P/E, which is why it makes up only about 1% of the fund's portfolio, Scruggs said. According to FactSet, the forward P/E for the stock is 28.9.

UGI Corp.

With Graco trading at a relatively high P/E, it made sense for Scruggs to name a cheaper stock. UGI Corp. (UGI) trades at a forward P/E of 8.6. He described the stock as "beaten up," in part because the company took on debt to acquire the portion of the old AmeriGas limited partnership it didn't already own.

Scruggs said UGI's natural-gas utility businesses in Pennsylvania and West Virginia are "doing fine," but that the company needs to address operational problems at AmeriGas, which he described as the largest propane distributor in the U.S. and Europe. He said another challenge for UGI is the refunding of some of its debt over the next year. "Getting past that will be a big step," he said, adding that he is confident in the company long-term.

Top holdings

About 9.5% of the FPA Queens Road Small Cap Value Fund was in cash as of Dec. 31, reflecting Scruggs's deliberate approach to finding companies meeting his criteria. Here are the largest 10 holdings of the fund as of that date (click on the tickers for more info about any company, fund or index):

   Company                                       Ticker   % of the FPA Queens Road Small Cap Value Fund as of Dec. 31 
   Fabrinet                                        FN                                                            5.4% 
   TD Synnex Corp.                                SNX                                                            4.7% 
   InterDigital Inc.                              IDCC                                                           4.4% 
   PVH Corp.                                      PVH                                                            4.1% 
   ServisFirst Bancshares Inc.                    SFBS                                                           3.7% 
   American Equity Investment Life Holding Co.    AEL                                                            3.3% 
   RLI Corp.                                      RLI                                                            3.1% 

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04-13-24 0714ET

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