20 August 2018

3 Small Stock Funds To Consider

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Small-capitalization stocks are standing tall.

For fund investors who are seeking exposure to the sector, the question now is which mutual fund or exchange-traded fund might make the most sense.

First, some background: The Russell 2000 index of small-cap stocks has climbed 10.3% since the start of this year, compared with 3.2% for the S&P 500 index of large-cap stocks (excluding dividends), as small stocks have benefited disproportionately from the tax cut passed last year, stronger growth in the U.S. than overseas, a rising dollar since mid-April and global-trade disputes.

And some experts say the trend will continue. “With economic data still solid, small-cap stocks probably have more runway in the months ahead,” says Michael Sheldon, chief investment officer at RDM Financial Group-HighTower Advisors in Westport, Conn.

Tax play 

Lower taxes tend to help small companies more than bigger ones, because effective tax rates generally are higher for small companies, given the wealth of tools that large companies have to reduce their tax burden.

Domestic economic growth, meanwhile, can boost small-cap stocks more than large-caps, because bigger companies are more dependent on foreign markets. Companies in the S&P 500 receive about 30% of their revenue from abroad on average, compared with 21% for Russell 2000 companies, according to Bank of America Merrill Lynch.

On the currency front, a rising dollar hurts U.S. companies that export by making their goods more expensive in foreign currencies, and it hurts the profitability of U.S. companies with sales overseas by making that revenue worth less when translated into dollars. So again, small-cap companies benefit from having a smaller exposure overseas than their large-cap brethren.

“The dollar trend is likely to continue, and if so, small-caps should continue to benefit,” says Jack Ablin, chief investment officer at Cresset Wealth Advisors in Chicago. The Federal Reserve’s continuing interest-rate increases combined with the reluctance of foreign central banks to raise rates should boost the dollar, he and others say.

Worsening trade disputes, too, would hurt large-cap stocks more than small-caps, because large-caps are more dependent on trade than small-caps, experts say. “Investors are now showing more interest in small-caps to hedge exposure to trade skirmishes,” says Karim Ahamed, an investment adviser at HPM Partners in Chicago.

Inflation factor 

Even the recent acceleration of inflation has helped small-cap stocks, says James Paulsen, chief investment strategist of Leuthold Group in Minneapolis. Inflation tends to benefit small companies more than large, because small companies generally have narrower profit margins than large companies. So, higher prices for their products represent a larger portion of small-company profit margins and thus boost earnings more for small companies than for large ones.

In addition, valuations of small-cap stocks are attractive, some analysts say. By one measure of value—the ratio of enterprise value (which takes into account a company’s market capitalization and debt, among other factors) to earnings before interest, taxes, depreciation and amortization, or Ebitda—the Russell 2000 was at a 12% premium to the Russell 1000 index of large-cap stocks as of May 31, Mr. Sheldon says, citing data fromBarclays . That compares with a median premium of 14.1% for the period from Dec. 31, 2003 through May 31, 2018.

“For a while it looked like small-caps were overvalued, but that has narrowed dramatically,” Mr. Ahamed says. “On a relative valuation basis, now is a better time to invest in small-caps.”

If you’re thinking of taking the plunge into small-cap stocks, what mutual funds might you consider? Russel Kinnel, director of manager research at investment information firmMorningstar , lists three possibilities: a small-cap value fund, a small-cap growth fund and a small-cap blended (growth and value) fund.

VALUE: DFA US Small Cap Value Portfolio (DFSVX)

“Because their expertise is small-cap and value, this seems like a good expression of what DFA does well,” Mr. Kinnel says, referring to Dimensional Fund Advisors, the fund’s sponsor. This fund finds inexpensive stocks based on price-to-book valuations, and it holds more than 1,000 names.

“Because holdings are cheap and small, you get more volatility than you’d expect from a diversified portfolio, but it’s a consistent performer,” Mr. Kinnel says. The fund had a five-year annualized return of 10.8% through the end of June.

GROWTH: T. Rowe Price QM U.S. Small-Cap Growth Equity Fund (PRDSX)

The fund is managed based on so-called quantitative analysis, which relies on mathematical equations to analyze various data for a company and its shares. The fund managers look at valuation, profitability, capital allocation, earnings quality and stock-price momentum. “It seems to be a good process,” Mr. Kinnel says. “It’s very diversified with 300 stocks.”

The fund produced a five-year annualized return of 14.6% through the end of June.

BLENDED: Harbor Small Cap Value Fund (HISVX)

Despite the name, Morningstar classifies this fund as blended. “They have growth-like qualities to their portfolio construction,” Mr. Kinnel says. It’s an unusual strategy based on pattern recognition, looking for characteristics to identify stocks that are likely to outperform.

With about 60 holdings, this portfolio is more concentrated than the average small-cap fund. “But it’s not like you will live and die on two names,” Mr. Kinnel says.

The fund generated a five-year annualized return of 13% through the end of June.

Click here for the original article from The Wall Street Journal.  

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