As the fallout from the trade war becomes a paramount concern for many investors, small-cap funds have seen an influx over the past year as investors shun larger caps due to their exposure to overseas economies.
According to Morningstar, while the exodus from large-cap funds continues, small-cap growth funds returned an impressive 8.7% for the quarter.
By comparison, the second quarter average total return for diversified U.S. stock funds was only 3.7%, according to Thomson Reuters Lipper data, bringing a modest gain of 3.4% year to date.
The results from a measure that that seeks to rank the returns of top-performing mutual funds confirms the small-cap sector has dominated the market. Three actively managed small-cap funds were at the top of the Wall Street Journal’s quarterly Winners’ Circle contest, each logging particularly stellar returns of over 40% for the trailing 12-month period ended June 30.
The top performer was Kinetics Small Cap Opportunities Fund, managed by James Davolos and Peter Doyle. The $300 million fund posted a total return of 44.1% for the past 12 months, edging out its nearest rival, Delaware Smid Cap Growth Fund, which turned in a return of 43.9% for the same period.
Nipping at their heels were Virtus KAR Small Cap Growth Fund and Lord Abbett Micro Cap Growth Fund, each showing respective returns of 43.2% and 42.8%.
Virtus’ current gain comes on the heels of its equally impressive first-quarter, 12-month trailing return of 40.8%, which at the time far outshined the 17.1% return for the S&P 500.
Each of the top performers had one attribute in common. All of the funds had a value investing component to their overall investment strategy. Several stock picks by the managers of some of the best small-cap fund performers illustrates how assiduously adhering to a value investing strategy can reap rewards in terms of finding stocks the market has overlooked.
In keeping with the importance of the value investing component of their successful overall strategy, several of the funds have managed to find significantly undervalued stocks.
Davolos, manager of Kinetics, attributes his success to looking for niche businesses that are very idiosyncratic or are out of favor with the larger funds. “You really need to do something different to earn real risk-adjusted returns in this market,” he said.
Following the gospel according to Graham-Dodd, the Kinetics fund managers look to invest in small businesses whose stocks are selling far below their intrinsic value, as indicated by an examination of their fundamentals. As investors realize their errors, they assume the share price will rise accordingly.
Over the past year, one of the fund’s biggest contributors to its total return was Texas Pacific Land Trust (TPL, Financial), with extensive holdings in the Delaware Basin region. During the fracking boom, Kinetics noticed the company earned higher royalty revenues and profited handsomely from selling access to those who needed to build roads and pipelines or access water for fracking.
According to Davolos, in 2000, Kinetics acquired, on a split-adjusted basis, a position in Texas Pacific at less than $6 per share. The stock currently sells for $719.
Perhaps the fund’s biggest and classic value investment play was Howard Hughes Corp. (HHC, Financial), a real estate development company shunned by investors for failing to generate any yield. Ignoring the lack of a current yield, Davolos and his fellow managers found the stock was trading for far less than its book value in 2010. The fund took a position at $40 and the company now trades for $138.50.
Other funds have found similar success adhering to classic value investing philosophy by pursuing largely unknown companies not followed by the larger-cap funds, which have yielded excellent gains responsible for the small-cap funds impressive overall returns.
For example, Alex Ely, manager of Delaware Smid Cap Fund, seeks out a small group of obscure companies that fit within a particular business theme. One theme was the increasing importance of mobile or online services now provided by companies that traditionally were only available to consumers through their stores.
Following this strategy, Ely liked a play with Weight Watchers (WTW, Financial). Following consumers preferences for apps that help them manage diet and exercise, the company’s operations followed suit, offering online meetings and support. The fund purchased the stock at an average price of $23.18; it now sells for $102.42.
Another example of a small-cap fund finding success following the precepts instilled by Benjamin Graham is consistent performer Virtus KAR Small Cap Growth Fund. For Virtus, the strategy remains the same: finding strong companies that will outperform the market in any environment. One good payoff for the fund was Virtus manager Todd Beiley bucking the consensus by purchasing shares of Old Dominion Freight Line Inc. (ODFL, Financial), which was depressed due to an industry-wide slump. Beiley took a position for $68.32 in September 2016; the stock now sells for $147.39.
Jack Ablin, chief investment officer of Cresset Wealth Advisors, reminds investors that “small-cap stocks aren’t always buy-and-hold investments.” Some businesses collapse. Others stagnate and flounder. A handful may become tomorrow’s giants. The challenge requires a lot of research—as this quarter’s winning managers would be the first to acknowledge.
Although small-cap funds have provided outsized returns compared to the larger-cap market, whether they can maintain their phenomenal performance remains to be seen. A downturn in the economy could affect smaller companies disproportionately. But for now, those investors who signed on to the small-cap bandwagon early are reaping generous rewards.
Disclosure: I have no positions in any of the securities referenced in this article.
