Q&A: Small caps on a roll ... can it last?


So far, it’s been a great year for stocks and an even better one for the small-cap variety. In 2013, according to Bloomberg, small caps have rallied almost twice as fast as larger companies in the U.S. While it’s not surprising that small caps have led the way even during a lackluster economic recovery, the question is, can this strong performance continue? We asked small-cap value manager Lawrence Creatura for his views.

Q: Do you think the current bull market for small caps can keep going? The answer is yes, and for two reasons. One is that the small-cap market is so dynamic. Over time, new companies come into being from the idea stage while larger companies that may have temporarily stumbled move back into small-cap territory. Likewise, other small companies grow into large companies. So it’s not always the same group of stocks that are in the small-cap space over time. It’s a universe that’s constantly being replenished with new potential.

A second reason small-cap stocks have room to run is because the economy is slowly improving, which has led and will continue to lead to earnings growth. A portion of the movement we have already seen in these stocks has been earned because the companies have been generating more cash flow. If the economy continues to improve, even at the current grudging pace, it will mean small-cap stocks, as well as other stocks, can continue to rise.

Q: Is it becoming harder to find attractively priced small-cap stocks? It’s true that the improving economy has broadly benefited small-cap stocks. But within the expansive small-cap environment, there are always pockets of opportunity. Consider the Russell 2000, representing 2,000 small companies, each with unique attributes and at different stages in their industry cycles. Some are doing quite well and have become expensive. Others aren’t performing strongly, while still others have exciting initiatives underway that haven’t yet been identified by the market. So while investors are likely to benefit from a more selective approach at this point, there are plenty of places to look.

Q: Are there factors that continue to support small caps? A long-standing tailwind for smaller stocks is what’s known as the small-cap effect. It’s an academically proven observation that small-cap stocks, over time, outperform their larger counterparts.1 This phenomenon has been demonstrated throughout different time periods, within different exchanges and in different geographies.

A second factor, as I mentioned, is that smaller stocks do better when the economy is improving. Small stocks have more operating leverage and more of what happens at the top of the income statement tends to flow down to a small company’s bottom line. A third factor is that compared to large caps, small caps have a slightly higher concentration of revenues generated domestically. At a time when the U.S. is one of the global economic bright spots, comparatively speaking, that tilt toward domestic revenue generation is likely to further support small-cap stocks.

Q: What sectors/industries have you been looking at recently? Any themes you find interesting? One theme we like in the Consumer Discretionary space is linked to movie-going. For a time this industry was priced as if no one was ever going to leave their living rooms to watch movies. That’s not the reality. Movie-going continues to grow in both numbers and dollars spent. The draw is that it’s a relatively inexpensive night out for adults and teens in particular. The industry has been very intelligent about keeping the experience both valuable and economical. There are a range of companies in the small-cap space that have great potential to capture opportunity related to movie going, from production companies to theatre operators to those that sell the advertising that we movie goers can’t easily escape.

Within the Tech sector, we’re seeing opportunity in the semiconductor capital equipment industry. There is an ongoing “arms race” with respect to semiconductor fabrication. Each generation of fabricators—the factories that manufacture semiconductor equipment—has gotten larger and more expensive to build. Whereas these facilities used to cost hundreds of millions of dollars, they now run into the billions. As a result, there are fewer companies building new fabrication centers. This arms race is helping to generate revenue and competition among the equipment suppliers for these centers, many of which are small companies.

Q: What’s your outlook for small caps heading into 2014? While it’s impossible to predict specific events that will drive the economy and markets, we believe the dynamics that make the small-cap asset class attractive will be in play next year and for years to come. Of course as value investors, our view is that a significant driver of small-cap returns will be generated from undervalued high-quality companies that have the potential to deliver strong earnings growth. Importantly, small companies will continue to be created and to innovate, expand and serve as essential engines in our economy, which gives them strong potential to play that role in investment portfolios.

Thank you, Lawrence.

1 Based on research by Nobel Prize-winning economist Eugene F. Fama, of the University of Chicago, and economist Kenneth R. French, of Dartmouth College.
Views are as of the date above and are subject to change based on market conditions and other factors. These views should not be construed as a recommendation for any specific security or sector.
Russell 2000® Index: Measures the performance of the 2,000 smallest companies in the Russell 3000 Index, which represents approximately 8% of the total market capitalization of the Russell 3000 Index. Investments cannot be made directly in an index.
Small-company stocks may be less liquid and subject to greater price volatility than large-capitalization stocks.
Value stocks tend to have higher dividends and thus have a higher income-related component in their total return than growth stocks. Value stocks also may lag growth stocks in performance at times, particularly in late stages of a market advance.
Federated Global Investment Management Corp.
Copyright © 2014 Federated Investors, Inc.

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