Opinion: A small-cap fund expert explains why you need to invest in small companies: they are the unexplored gold mines of the stock market.

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

For guidance on investing in small-cap companies and names to consider, I recently spoke with a mutual fund manager with over 50 years of experience investing in companies. small, little known. That would be Chuck Royce, of Royce Investment Partners.

When Royce founded his small-cap investment shop in 1972, there were only 13 small-cap mutual funds. Investors can now choose from over 500 small-cap funds plus over 100 small-cap exchange-traded funds (ETFs).

Not only does Royce bring wisdom from more than five decades of investing, but he also has a solid track record that backs his approach. His Royce Pennsylvania Mutual Fund

beat the Morningstar US small-cap index by 1.5 and two percentage points annually over the past three and five years.

Here are three key lessons learned from Royce about the stock market in general, the tactics that helped him outperform, and some of his favorite small-cap names to consider.

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

3- and 5-year trailing returns for small-cap stocks for most of the second half of 2022 were around 4%-6%. That’s predictable, because it’s been about 10% below the group’s long-term average since 1978. Historically, periods of below-average returns have been followed by solid performance of almost 100%. time, Royce said. He added: “We believe the valuation is in the right place. “We think this stage is set for the asset class to recapture the market leadership from large caps.”

2. Small-caps will beat “FAANG”: The low interest rate environment of the past few years has created favorable conditions for companies to rely on rising earnings in the distant future. Those distant returns appear larger when discounted back to the present at a lower rate. That’s no longer true, now that percentage is higher.

This change will hinder the performance of “FAANG”: Meta Platform


; Apple

); Netflix

and the alphabet
Royce said small-cap companies will dominate the market. “The underperformance of small-cap stocks relative to the FAANG is phenomenal,” he said. “This has established an absolute and relative pricing advantage.”

‘The entry point should be slow and deliberate. You want a great average price.’

3. Don’t worry too much about the “retest”: A debate now is whether the market will retest the October 2022 low. “I don’t think it’s too important,” Royce said. “I know we’re in the eighth or ninth inning of this decline.”

There’s no need, he says, to pinpoint the exact moment to buy for two reasons:

First, he commented, there is a great multi-year period ahead for small-cap stocks, so you should do OK even if you don’t 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 won’t buy it. In the end, it’s the average price you pay that matters. Entry points should be slow and deliberate. You want a great average price.”

stay small

Here are the three investment strategies Royce says have contributed to his performance and the five stocks he picks out now, along with an additional name:

1. Focus on quality: Besides favorable pricing, Royce likes to look for quality. “Quality” is a subjective concept in investment. But for Royce, the most important thing was to find a long-term and sustainable advantage. This could 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.

An example is Artisan Partners Asset Management
an investment firm with approximately $138 billion under management. Royce classifies it as quality because it has a great reputation based on its investment and management returns. He also likes that it’s a “lightweight asset,” which means it doesn’t require a lot of capital expenditure. So free cash flow is high. Royce thinks the stock price could double over the next three to five years.

Another example is Morningstar
provides investors with analysis, 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 compelling way in the last 15-20 years, from just rating mutual funds to various activities in publishing and money management,” Royce said. “They have done a phenomenal job of accumulating clients and recurring income, which is very important.”

2. Long-term thinking: Royce likes to enter into what he calls a long-term contract. “I like to think I can own a company forever,” he says. “That thinking wasn’t obvious to me 30 or 40 years ago, and most of the time it’s not obvious in the market either. But we feel comfortable holding stocks for 10 years or more.”

He says this gives him an edge in the investment world, where a lot of people focus on the short-term. One position he says he would comfortably hold for the next 10 years is the Ralph Lauren apparel, footwear and accessories company.
Its strong brand puts Ralph Lauren in the quality category. “It’s an exception to a story where most brands fade over time,” Royce said.

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%). “The opportunity to grow is very good around the world,” Royce said of Ralph Lauren’s prospects. “As the world continues to evolve, they will do well.” Global growth delivers the long-term compound recurring income Royce wants to see.

Another long-term holder is Air Lease
Company buys aircraft from Boeing

and Airbus

and leased to airlines. Air Lease supplies more than 200 airlines in about 70 countries. This makes it a game for the growing middle class in emerging market countries. People travel more when they make more money. It’s also a game in the long-term replacement cycle as airlines opt for more fuel-efficient, modern aircraft. Air Lease owns about 420 aircraft and plans to double its size with the purchase of 400 more by 2029. This supports the long-term holding argument.

3. Make friends with growth: Royce is basically a value manager but he likes to add some growth stocks to enhance his profits. No need to grow too fast – 10% -12% is fine.

An example is Kennedy-Wilson Holdings
a real estate company that invests in multifamily and office properties in the United States, United Kingdom and Ireland. The company uses its strong balance sheet and cash flow to find bargains in a weak property market. Wall Street analysts are predicting 21% annual mid-term earnings growth for the company.

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

Here’s an extra tip: Unlike many out-of-the-box managers, Royce doesn’t profit by betting on a concentrated portfolio of performance. Instead, he tends to maintain full diversification to reduce risk for a company. For example, his largest position in the Royce Pennsylvania Mutual Fund is the software company Agilysys.
represents less than 2% of the portfolio. In contrast, the top holdings at many mutual funds are between 3% and 5%.

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

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