Don’t count small-cap funds out because of looming interest rate hikes

Conventional wisdom holds that small-company stocks get flattened like an ant colony in the way of an elephant herd. But it may be time for advisers to rethink that, according to Standard & Poor’s.

Small-company stocks could have several potential problems if the Federal Reserve starts to hike rates soon, as Fed chair Janet Yellen hinted broadly on Friday. The first is that very small companies rely on bank loans for financing, and that financing is typically in the form of adjustable-rate loans. As the Fed raises interest rates, those companies’ financing costs will rise, too.

Another worry: Small companies, particularly small-growth companies, pay less in dividends than big companies do. An investor has to base her buying decision on the discounted future value of earnings. For companies with no dividends, the process would treat the stock like a bond with virtually no maturity, making it highly vulnerable to interest rate hikes.

On the other hand, the stock market has been anticipating a Fed rate hike for the entire year, and small-cap stocks have been clobbering their larger brethren. Small-cap value funds, for example, are up an average 11.29%, vs. 4.00% for large-cap value funds and 7.67% for the Standard & Poor’s 500 stock index with dividends reinvested.

And in the aftermath of Ms. Yellen’s speech, small-cap stocks held up better than large-caps, said Sam Stovall, U.S. equity strategist for S&P Global Market Intelligence. One reason for that: 83% of S&P 500 companies pay a dividend, and those dividends may be less interesting after two more rate hikes, he said.

“Maybe the “great rotation” pertains less to stocks versus bonds than it does between large- and small-cap equities,” Mr. Stovall wrote in his note to clients.

A rate hike is also likely to push up the value of the U.S. dollar, which would make U.S. exports more expensive overseas. “In the past 36 months, the S&P 500 has recorded a 0.72 monthly correlation with the U.S. Dollar Index (DXY) versus a correlation of 0.55 for the S&P SmallCap 600,” Mr. Stovall noted.

Most small-cap stocks, moreover, are focused on the domestic U.S. market. And, he said, growth projections for U.S. small-cap companies look better than those for larger company stocks.
Careful fund selection is important for any adviser. Those who want index products should consider exchanged-traded funds such as the iShares Russell 2000 Value (IWN), up 14.10% this year, or the Vanguard S&P Small-Cap 600 Value ETF (VIOV), up 15.57%. A low-cost core alternative would be iShares Core S&P Small-Cap (IJR), which charges just 0.12% in fees. You should be aware, though, that the fund, which has risen 12.93% this year, has more than $20 billion in assets — an enormous horde for a small-company fund.

The actively managed small-cap funds leading the pack this year are largely value funds. The leader: The $139 million Aegis Value (AVALX), up 58.3%. It’s got 43% of its holdings in basic materials stocks — primarily gold miners like Coeur Mining (CDE), a silver mining company that’s up 452% this year. Its largest holding, tobacco company Alliance One International (AOI) accounts for 12.6% of the fund’s assets, according to Morningstar. Alliance One is up 80% this year.

Hodges Pure Contrarian (HDPCX) is in second place among small-cap value funds. It owes much of its performance to a cluster of mining and energy stocks, such as Cliffs Natural Resources (CLF), which runs five iron ore mines in Michigan and Minnesota. The stock is up 265% this year. Southwestern Energy (SWN) is another portfolio favorite: It’s up 102%.

The growth side of the small-cap family hasn’t been as perky. The average small-company growth fund has gained 6.16%. The top-performing small-cap fund, Highland Small-Cap Equity Fund (HSZAX) has gained 25.16% this year, Morningstar said. Most of its big gains have come from energy companies, such as Dynagas LNG Partners (DLNG), up 63% this year.

Related Topics: BlackRock Inc., Vanguard Group