Tough times in the stock market lead people to focus on fear. When shares are tanking, many traders hold on to blue-chip, dividend-paying large-cap companies and bail out on smaller, growth-oriented but less secure names.
That tendency drives the relative performance of the smallest stocks down even more than the broad indices. Once things calm down, though, cooler heads prevail leading small and micro-cap names to stronger rebounds than the overall market.
The week ended March 24 saw the iShares Russell Micro-Cap ETF (IWC, Financial) hit a seven-year low valuation compared with the S&P 500 ETF (SPY, Financial).
Extreme readings almost always revert back toward normal, quickly and in a big way. That suggests one of today’s best trades would involve purchase of one or more proxies for the entire smaller company universe.
Don't simply take my word on this.
Here are historical facts that illustrate what happened as shares sold off then recovered in the past few cycles when micro-caps dropped to clearly out-of-favor levels similar to today's.
The tail end of the 2008 to 2009 bear market saw about 20% worse damage to shares of micro-cap companies. Brave souls who committed to buying them near that bottom were well rewarded. By the end of 2010, the micro-cap space had rebounded better than 50% more than the less hard hit, blue-chip segment.
2011’s European banking and original Greek debt panic sent small-caps down by about double the magnitude of large-cap issues. Traders were unwilling to shoulder what they deemed to be the extra risk of smaller companies.
That turned out to be a mistake. Once again, the micro-cap index turned in far better results than the SPY, from 2011's nadir through the end of 2013.
Stocks pretty much stagnated in 2015 before tanking badly in December. This year got off to the worst start in history. Nobody should be surprised that the smallest firms were once again hit the hardest.
Since bottoming intra-day on Feb. 11, both the SPY and the IWC have recovered by about 13%. As of March 24, micro-caps still lagged their large-cap brethren, though, by almost 8% year to date.
There is still plenty of time to position yourself for the inevitable catch-up surge when regression to the mean kicks in. The table below shows three Micro-Cap ETFs that are still cheap compared with one year ago.
The iShares ETF is far more liquid (more actively traded) than the other two ETFs listed below.
I prefer to own closed-end funds, which now sell at historically higher than normal discounts to their net asset values (NAVs). The two Royce funds have been around for decades and have posted outstanding long-term returns.
Closed-end funds can benefit shareholders in two ways that open-end mutual funds can’t do. While often available at discounts to NAV, all dividend and realized capital gain distributions are paid out to shareholders as 100-cent dollars.
Changes in discount levels can benefit closed-end shareholders in the same way fluctuations in PE ratios can help individual equity owners. When P/Es expand, positive changes in a firm’s EPS are magnified.
Here’s how a narrowing of a close-end fund’s discount can accomplish that same effect. The illustration is not far-fetched. Less than one year ago, 10% discounts were normal. Occasionally in the past they’ve shrunk much more than that, or even reached parity to NAV.
In the example shown above, a 10% rise in NAV morphed into an almost 19% shareholder gain.
Don’t be put off by small-caps’ disappointing trailing 12 month returns. Previous periods of underperformance have led to two-year (or longer) stretches of excellent results.
Owning small and micro-cap closed-end funds can take advantage of both the expected rebound in the asset class and the likelihood that CE fund discount levels move favorably over time.
That’s a double-barreled play for aggressive investors.
Disclosure: Long RVT, long RMT.
