How to Play the Small-Stock Comeback

Can small stocks build on their recent outsize gains, or was 2016 an anomaly?

That’s a particularly crucial question for those who watched the small-stock rally unfold on the sidelines and now wonder anxiously whether it’s too late to get a bit of the action.

Here’s how strong last year’s rally was: As 2016 drew to a close, Chip Reed, a portfolio manager at Atlanta Capital Management in Atlanta, was preparing to head off to a client meeting to apologize for posting a total return of only 19% for the year. That may sound absurd, after a year in which the S&P 500 index rose 9.5% and provided a total return, including dividends, of 12%.

But Mr. Reed manages portfolios of smaller and midcap stocks, and suddenly, those are the kinds that are dominating the market. A small-stock fund manager isn’t in a position to crow, relatively speaking, even with a 20% gain for the year. “Money was just flying into these stocks, especially into the [small-cap] banks,” Mr. Reed says.

What happened? After what Mr. Reed calls “the worst start of any year” that he can recall—with the Russell 2000 small-stock index stuck in a bear market in early February, down 26% from its high in 2015—small stocks regained their footing by midyear, playing catch-up as the profit picture began to improve for some companies and investors began to look more favorably on mining and energy stocks of all sizes following signs of strength in commodity prices.
Then small stocks exploded the day after the presidential election, in part due to bets that smaller companies—which skew toward domestic rather than international business—would benefit more than others from President-elect Donald Trump’s policies. With a gain of 11% in November alone, the Russell 2000 ended the year with a 19.5% advance and a total return of 21.3%.

Some analysts think this is more than just a postelection bounce for small stocks (generally defined as those with market values below $2 billion). They point to encouraging trends in corporate profits and those expectations for friendly government policies. But others advise caution, mainly because of the heights reached by valuations in the rally, and emphasize that investors who want into the market need to be selective.

Small-stock funds in lead
Investors in small-stock mutual funds had plenty to celebrate last year, with some reaping gains well beyond the Russell index’s stellar advance. According to data from Thomson Reuters Lipper, while large-cap funds posted average returns ranging from 1.8% (for growth funds) to 14.6% (for value funds), small-cap value funds, in particular, easily beat all of the other nonspecialist stock-fund categories, recording an average return of 26.8%.

The list of top-performing U.S.-stock managers in 2016, as measured by The Wall Street Journal’s Winners’ Circle contest, was dominated by small-stock skippers. The managers of Aegis Value Fund (AVFAX), a small-stock value fund, blew away the field with a 70.7% total return for the year to win the contest, followed by several other small-stock fund managers with 30%-plus gains. (More here on the contest and the winning manager, Scott Barbee of Aegis.)

Chasing this kind of outperforming asset class is tricky, however, even if the rally does continue. It’s possible that more gains lie in store, says Dan Suzuki, senior U.S. equity strategist at Bank of America Merrill Lynch. But the market already has priced in a lot of good news, he adds, and valuations are high. “You want to be more cautious than usual; the bull case for small stocks is very much based on sentiment,” he says.

For those who want to join the party, it’s important not to just grab anything with a small-cap name and hope to replicate the overall performance of the small-cap sector, Mr. Suzuki says. Only 45% of small-cap funds were beating their benchmark as of the beginning of December, he says.

And investors need to be sure of exactly what they’re buying, Mr. Suzuki says. Many small-stock fund managers own a smaller percentage of the stocks in their benchmark than a large-cap manager would of S&P 500 stocks, he says, leaving more room for their funds to stray from the benchmark’s performance. And some fund portfolios may include midcap stocks.

What could go wrong
There are a number of possible headwinds for small stocks, chief among them the fact that Federal Reserve policy makers have resumed raising interest rates precisely as small-stock valuations have moved into nosebleed territory.

“There’s a bit of a raging debate within my group about whether the optimism has gone too far,” says David Lafferty, chief market strategist at Natixis Global Asset Management, who says he is among those who are cautious, especially in the wake of the postelection rally. “Last year you had the long-term asset-allocation argument in your favor—that these stocks outperform over the long run—and you had valuation in your favor.” Today, he says, the magnitude of the rally has weakened those arguments for new investment in small stocks, though these shares still give an investor diversification.

A year ago, few investors would have been prepared to bet that such a dramatic outperformance was on the cards. The Russell had been a laggard for years. Some analysts, however, had been anticipating a recovery because of an upswing in small companies’ profits, and some see corporate earnings continuing to support the market.

“The profits recession is ending, and we began seeing some incremental improvement in December” of 2015, says Lisa Kirschner, director of research for Richard Bernstein & Associates.

Among all stock groups, Ms. Kirschner says, smaller stocks had the biggest improvement in earnings growth, on a year-over-year basis, between the second and third quarters of 2016, and that puts the rally on a solid footing.

“We see an earnings-driven market that we think will continue into 2017,” she adds. “These are quite positive indicators, even though at some point, these companies will run into a tug of war” between higher interest rates and rising profits.

Ms. Kirschner sees potential for the small-stock rally to broaden.

So far, she says, it has been driven by the most cyclical parts of the market, as those companies’ profits come off a cyclical bottom. That’s why it’s the small-cap value funds that are leading the way, rather than small-cap growth funds, which as a group returned 10.1% in 2016. But she expects more companies to report earnings growth.

“Value is a typical outperformer,” she says. “These cyclical components tend to outperform first and fastest, then others play catch-up.”

Trump factor
Whatever the near-term profit outlook, much of the impetus behind the spectacular rally in smaller stocks since Mr. Trump’s election has to do with expectations for the longer-term impact of the president-elect’s policies on this group.

Those investors who have piled into small stocks since Election Day are making a straightforward bet. Mr. Trump’s platform has a protectionist tilt, and small stocks tend to have a domestic focus. Logically, they should thrive, at least on a relative basis, in an anti-free-trade environment.

And since smaller companies struggle to benefit from the tax-reduction strategies that their larger counterparts can use readily, Mr. Trump’s pledge to cut the corporate tax rate also should boost small-cap profits.

Meanwhile, financial stocks are the biggest sector in the Russell 2000, and the many smaller banks in the Russell have soared as investors react to promises to cut financial regulations.

Overall, argues Mr. Lafferty, the market environment remains positive, “but you have to have to those earnings materialize, because the high valuations are hanging over this market now. You’ve already generated a lot of the performance you’re going to get” without additional gains in earnings.

Source: Suzanne McGee,