While some investors have sought shelter in companies like Procter & Gamble or Johnson & Johnson because of their steadiness and rich cash cushions, a group of investment managers has been looking for comfort at the other end of the market, with the likes of US Ecology and McGrath RentCorp.
Never heard of those firms? Well, that's part of the allure for Seth Reicher, managing director of Snyder Capital Management, which manages $1.7 billion. Reicher has been "backing up the truck" on some smaller companies after lightening up on them as recently as 18 months ago. These firms not only are relatively unknown but also tend to be overlooked by investors who are searching for comforting dividends or hefty cash piles. Yet, 25 percent of the stocks in the Russell 2000 index pay a dividend of more than 2 percent. The best part: Smaller companies are more likely to possess a quality that investors always cherish -- fast growth in sales and profits.
Many analysts expect the U.S. economy to gain a paltry 2 percent this year -- and that's good compared with forecasts of a recession in Europe. However, analyst projections for the small firms that make up the Russell 2000 are high. They're expected to increase profits, on average, by almost 30 percent, five times as much as firms in Standard & Poor's 500-stock index. "That kind of double-digit profit and sales growth is hard to come by right now," says Steven DeSanctis, head of U.S. small-cap strategy at Bank of America Merrill Lynch, who expects smaller companies to generate returns close to their historical average of about 11.5 percent.
With their better growth prospects, such small fry also make very good acquisition targets. Larger companies often look for ways to jump-start their own growth, and they are sitting on almost $1 trillion in cash, says Paul Hogan, comanager of the FAM Equity-Income fund. Although many big-name companies are swimming in record profits lately, much of their recent growth has come from cost-cutting and productivity improvements; many smaller firms are generating growth through sales increases that are probably more sustainable, says Michelle Stevens, small-cap value portfolio manager at Baird Investment Management.
To be sure, small caps are generally riskier propositions. The group has also had a strong run so far this year, now trading above long-term historical averages on several measures. In addition, when the market swings into one of its risk-aversion modes, small companies get hit hard -- often indiscriminately. That's one reason investors are flocking to a particular type of small firm: The kind with plenty of cash and profits and with a dominant market niche (in the market's lingo: a quality firm).
Of course, part of the reason investors favor small caps is their long-t
erm record. A $10,000 investment in the Russell 2000 a decade ago would have grown to more than $17,000 last year; in a large-cap index, to less than $14,000. But small firms lagged larger stocks in 2011, with the Russell 2000 down 4 percent and the S&P 500 up 2 percent, after dividends. The highest quality stocks -- those companies that get the most profits out of their capital -- have been trading at a 6 percent discount to large companies, according to fund firm Heartland Advisors. To some managers, it seems pretty clear: "If you want to get good growth and stability, you can get that in small caps, in spades," says Mark Coffelt, portfolio manager for Empiric Core Equity fund. Just don't tell everyone about it.
Some small-cap stocks, including the following, are growing their profits fast and trading at an attractive price, analysts say.
- McGrath RentCorp (MGRC)
- US Ecology (ECOL)
- The Andersons (ANDE)
- Rent-A-Center (RCII)
- Life Time Fitness (LTM)
- Valmont (VMI)
Corrections & Amplifications
Seth Reicher's name was originally misspelled in this story.