Investing in Small Companies Offers Big Upside

Why are small-cap stocks a big deal and opportunity for investors right now? They are trading a full 10 percent below their long-term average p/e ratio, according to Bank of America analysts. And that’s not all.

With more than five decades of experience in small-cap funds and businesses, Chuck Royce of Royce Investment Partners offers insights on this market. He clearly knows what he’s talking about: His Royce Pennsylvania Mutual Fund has beat the Morningstar U.S. small cap index by 1.5 and 2 percentage points annually over the past three and five years, respectively, and Royce has thrived during the market highs and lows for more than 50 years.

Here are his tips for approaching the small-cap market:

• Small caps are ready to take the stage. While 2022 was not their year, small caps are ready to shine in 2023, since they typically follow up years of sub-average performance with solid ones, according to Royce. “We are convinced that valuations are in the exact right spot,” Royce said. “We think the stage is set for the asset class to retake market leadership from large cap.”
• Timing isn’t everything. While some investors are concerned about another retest of last fall’s lows, Royce is less concerned about timing and buying at the perfect price. He believes we are at the tail-end of a decline and that investors should focus on average price, rather than waiting for the absolute low.
• Rate changes can change everything. While companies that focused on earnings growth in the distant future may have outperformed in times of low interest rates, a higher-rate environment will give small caps a real advantage.
• Quality, quality, quality. Royce points to stocks with a sustainable advantage—whether a solid brand/reputation or revenue/strong return on capital—as the quality he seeks.

Artisan Partners Asset Management, APAM, 1.25%, has about $138 billion under management as well as impressive management and returns, which puts it in Royce’s “quality” camp. Likewise, Morningstar, MORN, +0.14%, boasts a wealth of licensing, subscriptions and money management that combine to equate to notable recurring revenue.

• Invest for the long term. Long-term compounders—”I want to think I could own a company forever,” Royce said—should be a focus for investors, who are often skittish about holding stocks for a decade or more.

He suggests Ralph Lauren, RL, 2.05% as a business with an exceptional brand story and legacy as well as international expansion and growth. In addition, Air Lease, AL, 2.27%, which leases aircraft to other companies, is another longer-term opportunity.

• Add growth stocks to the mix. Even 10-12 percent growth stocks can impact returns—investors don’t have to look for the giants every time. For example, Kennedy-Wilson Holdings KW, -0.55%, a real estate company that invests in multifamily and office properties, is known for finding bargains in weak real estate markets. Analysts project greater than 20 percent medium-term annual earnings growth.

Interestingly, when Royce founded his investment company in 1972, there were just 13 small-cap mutual funds in existence. Today, there are more than 500—not to mention more than 100 small-cap exchange traded funds. From those early days to today, Royce has remained committed to staying fully diversified to manage risk. The biggest position in his Royce Pennsylvania Mutual Fund, for example, is software company Agilysys AGYS, 1.25%, representing less than 2% of the portfolio.