Why smaller stocks' struggles in 2014 are making some small-cap investors more optimistic

Economic Indicators Associated Press

This year has felt like a hangover for owners of small-cap stock funds.

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On several occasions, small-cap stocks have dipped by more than 7 percent in just a matter of weeks. All told, they're close to flat for the year, a letdown from 2013 when they surged 37 percent. And the performance looks even worse when compared with large-cap stocks, which are up 11 percent. The last time small-caps had this bad a year relative to large-caps was when Google was still operating out of a garage in 1998.

The stall for small-cap stocks isn't a big surprise. Many fund managers early this year called them overpriced following their heady performance in 2013 and much of the decade before. Small-caps also often lag the rest of the market when the economy moves out of the early stages of recovery and begins to gain momentum.

But the underperformance has also raised optimism for some mutual-fund managers because it has made small-caps relatively less expensive. To be sure, no one argues that small-caps as a group are cheap, whether they're valued based on their earnings or other measures. But managers point to several factors that could help small-caps in 2015. Since hitting a bottom in mid-October, the Russell 2000 index of small-cap stocks has risen faster than the broader market.

Consider Drew Weitz, one of the managers of the Weitz Hickory fund, which focuses on smaller companies with a market value of less than $10 billion.

Weitz considers himself a value investor, and if he can't find any attractively priced stocks, he's comfortable not buying anything. Bargains were so tough to find at the end of 2013 that the Hickory fund had more than 30 percent of its assets in cash, versus its norm of 10 percent to 20 percent.

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Prices have since dropped enough to grab his attention. By the end of September the fund was down to about 20 percent in cash. In the first two weeks of October, small-caps had another jagged drop, quickly losing nearly 5 percent. Weitz pounced and bought more, including stock in Allison Transmission. He had been watching the maker of transmissions for trucks and other vehicles since January, waiting for it to get cheap enough to buy.

Allison Transmission now trades at 27.5 times its earnings per share over the last 12 months. In February its price-earnings ratio was above 42.

Among other factors managers say could help small-cap stocks:

— BUY AMERICAN

Companies that do most of their business at home appear to have the advantage heading into next year. That would favor small-cap stocks, which depend less on foreign sales than their bigger rivals.

The U.S. economy finally seems to have reached a higher gear. Employers have added more jobs than in any year since 1999, and economic growth just had its best back-to-back quarterly performance since 2003.

Other countries around the world, meanwhile, aren't doing as well. Japan's economy is back in recession. Europe's is growing, but only barely. China is trying to navigate a slowdown in its growth.

Small-cap companies generally get about 15 percent to 20 percent of their revenue from abroad, says Christopher Beck, chief investment officer of the small-cap value team at Delaware Investments. Large-cap companies, meanwhile, get closer to 50 percent of their revenue from outside the U.S.

— STICK WITH THE DOLLAR

Small-cap stocks offer greater protection from not only weaker economies abroad but also their weaker currencies.

Procter & Gamble, for example, sells its razors and detergent around the world. It gets about 65 percent of its revenue from outside the United States.

Last quarter, it would have reported a 9 percent rise in its core earnings per share if currency values around the world had stayed flat. But the dollar is close to its highest level in years against the Japanese yen and other currencies. That made each yen of sales worth less in dollars than a year earlier. Procter & Gamble reported growth of only 2 percent last quarter.

— RIDE THE RISE IN BUYOUTS

CEOs are growing more confident, and they're more willing to make deals to boost growth. The total value of mergers and acquisitions this year is on track to be the strongest since at least 2007.

Buyouts can offer a quick way to jumpstart revenue growth, something that's been tough to deliver since the recession. Companies certainly have the financial strength to make the purchases. They're sitting on a near-record amount of cash, and low interest rates make it cheap to borrow.

A boost in buyouts should help small-cap stocks, which can make for attractive targets, says Delaware Investments' Beck. Last month, two of the companies in his Delaware Small Cap Value fund announced they were getting bought. And such deals generally mean a quick surge in price: Susquehanna Bancshares jumped 32.5 percent the day it said it was being acquired by BB&T.