After a stellar 2013 and so-so first half of 2014, small-cap stocks ran into a wall in the third quarter. The Russell 2000 index of smaller stocks tumbled more than 7% from July through September, and, since hitting an all-time high earlier this year, the index is down more than 10% -- entering into correction territory.
So, is it time to ditch small-caps? I don't think so. For one thing, while we didn't have one last year, corrections in small-caps are a regular occurrence. From 2004 through 2012, the Russell 2000 corrected 15 times, declining an average of 16.3%, according to USA Today (citing Russell data). Yet since 2004, the small-cap index is still beating the S&P 500.
What's more, over the long haul, history has shown that small-cap stocks -- particularly small-cap value stocks -- are a great place to look for investment ideas. So while the recent declines have been rough, I'm not ditching the little guys.
Consider the data. From 1927 through 2009, U.S. large-cap growth stocks averaged a 9.08 percent annual compound return, according to the data of Dartmouth College professor and noted stock researcher Kenneth French. Small-cap growth stocks, meanwhile, averaged 9.23 percent, and large-cap value plays fared even better, averaging 11.21 percent. But well ahead of the pack are small-cap value picks, which averaged a 14.17 percent return per year. (For the breakpoint between small and large stocks, French and colleague Eugene Fama use the mean market equity of New York Stock Exchange stocks. Growth stocks are defined as those in the bottom 30 percent of the market based on book/market ratios; value stocks are those in the top 30 percent.)
Is this just happenstance? Most likely not. There are a number of advantages that small-cap value plays have. Smaller companies, for example, just have more room to grow. Once a company gets to a certain size, it's not going to be putting up the huge growth numbers that smaller upstarts are putting up. And smaller companies are often more nimble and able to adjust to shifting conditions than are larger firms.
Another big advantage is that small stocks in general aren't as well known as their larger peers. That means they fly under the radar, getting less coverage from analysts and less attention from mutual funds. As mutual fund great Peter Lynch noted, funds often have rules in place preventing them from buying stocks with market caps below a certain threshold. That often means they can't buy small companies' shares until the stock's price - and thereby its market cap - has risen, and they are no longer great bargains.
Because of their under-the-radar status, smaller stocks tend to be more susceptible to mispricings that smart investors can take advantage of. And, if a small stock is getting a lot of attention, it's likely that it's a fast-growing firm with pricey shares, not a bargain-priced value pick. That's another plus for small-cap value plays.
A lot of the gurus upon whom I base my Guru Strategies recognized the benefits of small stocks - even those who can no longer focus on them, like Warren Buffett. Because of its huge size, his Berkshire Hathaway can't buy enough shares of a very small stock to really make an impact on Berkshire's overall returns in a big way. But at Berkshire's 2008 shareholders meeting, Buffett said he would think much differently if managing only a few million dollars. That, he said, would open up thousands of opportunities, mostly in small stocks and specialized bonds.
All of this doesn't mean that investors should focus only on small-cap value stocks. I believe in going after the best values in the market, regardless of where they are. But what it does mean is that when searching for bargains, you should make sure that you don't do what much of Wall Street does - ignore the unloved little guys.
Here are five small value stocks my models are high on right now.
Lannett Company ( LCI ): This Philadelphia-based generic pharmaceutical maker ($1.6 billion market cap) has high and rising profit margins (3.2% two years ago, 8.8% a year ago, and 20.9% in the current year), a low debt/equity ratio (0.34%), and a 0.62 P/E-to-growth ratio, impressing my Motley Fool-based model, based on an approach outlined by Fool co-creators Tom and David Gardner.
AAR Corp. ( AIR ): This Illinois-based aviation products firm ($1 billion market cap) has a 2.8 current ratio and less long-term debt ($549 million) than net current assets ($740 million), and trades for 14.9 times three-year average earnings and 0.96 times book value, earning high marks from my Benjamin Graham-based strategy.
Arctic Cat Inc. ( ACAT ): This Minnesota-based all-terrain vehicle and snowmobile maker ($430 million market cap) has no long-term debt and 5.5% average net three-year profit margins, and trades for just 0.6 times sales, getting high marks from my Kenneth Fisher-based model.
NeuStar, Inc. ( NSR ): This Virginia-based firm ($1.4 billion market cap) provides real-time information and analytics to the communications services, financial services, retail, and media and advertising sectors. The model I base on the writings of hedge fund manager Joel Greenblatt thinks it's a bargain. Greenblatt uses a remarkably simple strategy that looks at only two variables: return on capital and earnings yield. My Greenblatt-inspired model likes NeuStar's 13.8% earnings yield and 60% return on capital.
Heartland Payment Systems ( HPY ): This New Jersey-based firm delivers credit, debit, and prepaid card processing, payroll, check management and payments solutions, to more than 250,000 business locations across the US. My Greenblatt-inspired model likes the $1.7-billion-market-cap firm's 10.8% earnings yield and 100% return on capital.
I'm long NSR, HPY, ACAT, AIR, and LCI.