A small-cap fund guru explains why you need to invest in small companies: they’re the stock market’s undiscovered nuggets.

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Small-cap stocks are a great place to put your money right now because they’re cheap. How cheap? Bank of America analysts pointed out recently that this group trades 10% below their long-term average p/e ratio.

For guidance on how to invest in the small-caps and names to consider, I recently talked with a mutual-fund manager with more than 50 years of experience investing in small, lesser-known companies. That would be Chuck Royce, of Royce Investment Partners. 

When Royce founded his investment shop specializing in small-caps in 1972, there were just 13 small-cap mutual funds. Now investors can choose from more than 500 small-cap funds plus more than 100 small-cap exchange traded funds (ETFs). 

Not only does Royce bring the wisdom that comes from more than five decades of investing, he has a strong record that supports his approach. His Royce Pennsylvania Mutual Fund

beats its Morningstar U.S. small cap index by 1.5 and two percentage points annualized over the past three- and five years.

Here are three key takeaways from Royce on the stock market overall, the tactics that help him outperform, and some of his favorite small-cap names to consider. 

1. Small caps will shine: Royce agrees with Bank of America strategist that small-caps are cheap. But he uses a slightly different logic. He expects small caps to outperform because last year they did so badly. 

Trailing three- and five-year returns for small-caps over most of the second half of 2022 came in at around 4%-6%. That’s predictive, because it was below the group’s long-term average of around 10% since 1978. Historically, periods of below-average returns are followed by solid performance virtually 100% of the time, Royce says. “We are convinced that valuations are in the exact right spot,” he adds. “We think the stage is set for the asset class to retake market leadership from large cap.”

2. Small-caps will beat “FAANGs”: The low interest-rate environment of the past several years favored companies that bank on earnings growing in the distant future. Those distant earnings looked bigger when discounted back to the present at lower rates. That is no longer true, now that rates are higher. 

This change will hinder the performance of the “FAANGs”: Meta Platforms

; Amazon.com

; Apple

); Netflix

and Alphabet
Royce says small caps will take over the market’s leadership. “The underperformance of small caps relative to FAANGs was extraordinary,” he says. “This has set up an absolute and relative valuation advantage.” 

‘Entry points should be slow and deliberate. You want a great average price.’

3. Don’t worry too much about a “retest”: One debate now is whether the market will retest the October 2022 lows. “I don’t think it is terribly important,” Royce says. “I know we are in the 8th or 9th inning of this decline.”

There’s no need to get he timing exactly right on buying, he says, for two reasons: 

First, he observes, there is an excellent multi-year period ahead for small caps, so you should do OK even if you do not buy at the exact lows. Next, when entering positions, forget about the “perfect” price, he says. “Too many portfolio managers think they have to buy a stock at $12, so if the stock is at $13, they are not going to buy it. Ultimately it is the average price you pay that matters. Entry points should be slow and deliberate. You want a great average price.”

Staying small

Here are three investing strategies Royce says contribute to his performance, and five stocks he singles out now, plus a bonus name: 

1. Focus on quality: Besides favorable valuations, Royce likes to look for quality. “Quality” is a subjective concept in investing. But for Royce it boils down to finding a durable and sustainable advantage. This can mean companies with strong brands, strong reputations, recurring revenue, or pricing power. Evidence of quality also shows up in metrics including superior return on capital, free cash flow and dividends. 

One example is Artisan Partners Asset Management
an investment company with about $138 billion under management. Royce puts it in the quality camp because it has a great reputation based on its management and investment returns. He also likes that it is “asset-light,” which means there is not a lot of need for capital spending. So free cash flow is high. Royce thinks the stock price can double over the next three to five years. 

Another example is Morningstar
which offers investors analytics, data, independent research and money management services. Subscriptions, licensing, and money management generate substantial recurring revenue. This contributes to the quality of the business. “They have evolved in the most fascinating way over the last 15-20 years from just mutual fund ratings to variety of activities in publishing and money management,” Royce says. “They have done an extraordinary job of accumulating customers and recurring income, which is critical.”

2. Think long term: Royce likes to be in what he calls long-term compounders. “I want to think I could own a company forever,” he says. “That thinking was not obvious to me 30 or 40 years ago, and it is not obvious in the market most of the time. But we are comfortable holding stocks for 10 years or more.”

He says this gives him an advantage in an investing world, where so many people are focused on the short term. One position he says he’d be comfortable holding for another 10 years is the apparel, footwear and accessories company Ralph Lauren
Its strong brand puts Ralph Lauren into the quality camp. Says Royce: “It is an exception to the story that most brands fade over time.” 

Its strong brand also gives Ralph Lauren the power to expand globally. The company sells its products in North America (48% of sales), Europe (28%) and Asia (21%). “Growth opportunities are good around the world,” Royce says about Ralph Lauren’s prospects. “As the world continues to grow, they will do well.” Global growth provides the long-term compounding in recurring income that Royce wants to see.

Another long-term hold name is Air Lease
The company buys aircraft from Boeing

and Airbus

and leases them to airlines. Air Lease supplies more than 200 airlines in about 70 countries. This makes it a play on the growing middle-class in emerging-markets countries. People travel more when they earn more. It’s also a play on the long-term replacement cycle as airlines choose more fuel-efficient, modern aircraft. Air Lease owns about 420 aircraft and plans to double in size with the purchase of another 400 planes through 2029. This supports the long-term hold thesis.

3. Make friends with growth: Royce is fundamentally a value manager but he likes to add some growth stocks to enhance returns. It doesn’t have to be white-hot growth — 10%-12% is fine. 

One example is Kennedy-Wilson Holdings
a real estate company that invests in multifamily and office properties in the U.S., the U.K. and Ireland. The company uses its strong balance sheet and cash flow to find bargains in weak real estate markets. Wall Street analysts project 21% medium-term annual earnings growth for the company.

Air Lease is another example of a high-growth opportunity. Sales grew 11% last year, and analysts forecast 26% medium-term annual earnings growth. Morningstar also fits the bill: revenue grew 12.8% last year through the end of the third quarter. Ralph Lauren qualifies, too. The company projects 2023 sales growth in the high single-digits. Analysts forecast 8.5% medium term annual earnings growth. 

Here is a bonus tip: Unlike a lot of outperforming managers, Royce doesn’t get returns by taking concentrated portfolio bets that work out. Instead, he tends to stay fully diversified to reduce single-company risk. The biggest position in his Royce Pennsylvania Mutual Fund, for example, is software company Agilysys
which represents less than 2% of the portfolio. In contrast, the top holdings at many mutual funds are 3% to 5% positions. 

Michael Brush is a columnist for MarketWatch. At the time of publication, he owned META, AMZN, AAPL, NFLX, GOOGL and KW. Brush has suggested META, AMZN, AAPL, NFLX, GOOGL, APAM, RL, KW and AGYS in his stock newsletter, Brush Up on Stocks. Follow him on Twitter @mbrushstocks

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