Small-cap stocks are a great place to put your money right now because they are cheap. How cheap? Analysts at Bank of America recently pointed out that the group trades 10% below its long-term average p/e ratio. For guidance on how to invest in small-caps and names to consider, I recently spoke with a mutual-fund manager with more than 50 years of experience investing in smaller, lesser-known companies. That would be Chuck Royce of Royce Investment Partners. When Royce founded his investment shop specializing in small-caps 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 gained from more than five decades of investing, he has a strong track record that backs up his approach. His Royce Pennsylvania Mutual Fund PENNX, -2.53% has outperformed its Morningstar US Small Cap Index by 1.5 and two percentage points annually over the past three- and five-year periods. Here are three key takeaways from Royce overall in the stock market, the tactics that help him outperform, and some of his favorite small-cap names to consider. 1. Small caps will shine: Royce agrees with the Bank of America strategist that small-caps are cheap. But it uses a slightly different logic. He expects small caps to outperform as they did very poorly last year. Trailing three- and five-year returns for most small-caps in the second half of 2022 came in around 4%-6%. That’s predictable, since it was below the group’s long-term average of about 10% since 1978. Historically, periods of below-average returns have been followed by solid performance virtually 100% of the time, Royce says. “We are confident that the valuation is definitely in the right place,” he adds. “We think the stage is set for the asset class to regain market leadership from large caps.” 2. Small-caps will beat the “FAANGs”: The low interest rate environment of the past few years has favored companies that rely on rising earnings in the distant future. Those distant earnings looked large when discounted to current low rates. That is no longer true, now that rate is higher. This change will hinder the performance of “FAANGs”: Meta Platforms META, -4.55% ; Amazon.com AMZN, -1.09% ; Apple AAPL, -0.55% ); Netflix NFLX, -2.12% and Alphabet GOOGL, +1.30%. Royce says small caps will lead the market. “The underperformance of small caps relative to the FAANG was extraordinary,” he says. “This has set a specific and relevant valuation advantage.” “‘The entry point should be slow and deliberate. You want a great average price.’ ”
3. Don’t worry too much about “retesting”: One debate now is whether the market will retest the October 2022 low. “I don’t think it’s very important,” Royce says. “I know we’re in the 8th or 9th inning of this slump.” He says there’s no need to find the right time to buy for two reasons: First, he observes that small caps have a great multi-year period ahead, so even if you don’t buy, you should do just fine. Definitely lower. Next, when entering a position, forget about the “absolute” price, he says. “A lot of portfolio managers think they have to buy a stock at $12, so if the stock is at $13, they’re not going to buy it. After all, the average price you pay is important. Entry points should be slow and deliberate. You want a good average price.” Staying small Royce says here are three investment strategies that contribute to his performance, and five stocks he’s singled out now, plus a bonus name: 1. Focus on quality: In addition to favorable valuations, Royce likes to look for quality. “Quality” is a subjective concept in investing. But for Royce it boils down to finding a durable and sustainable advantage. This could mean companies with strong brands, strong reputations, recurring revenue or pricing power. Evidence of quality is also visible in metrics including superior return on capital, free cash flow and dividends. One example is Artisan Partners Asset Management APAM, -1.70% , an investment company with about $138 billion under management. Royce puts it in the quality camp because it has a good reputation based on its management and investment returns. It also likes that it’s “asset-light”, meaning it doesn’t require a lot of capital expenditure. So free cash flow is higher. Royce thinks the share price could double in the next three to five years. Another example is Morningstar Morn, -1.37% , which provides investors with analytics, data, independent research and money management services. Subscriptions, licensing and money management generate significant recurring revenue. This contributes to the quality of the business. “They’ve evolved very attractively over the last 15-20 years from just mutual fund ratings to publishing and various money management activities,” says Royce. “They’ve done a phenomenal job of accumulating customers and recurring revenue, which is important.” 2. Long Term Ideas: Royce prefers what he calls long-term compounders. “I’d like to think I could own a company forever,” he says. “The idea wasn’t clear to me 30 or 40 years ago, and it’s not clear to most of the market. But we’re comfortable holding the stock for 10 years or more.” He says that gives him an advantage in the world of investing, where many focus on the short term. One position he says he’ll be comfortable holding for another 10 years is apparel, footwear and accessories company Ralph Lauren RL. -1.12%. Its strong brand puts Ralph Lauren in the quality camp. Royce says: “It’s an exception to the story that most brands fade over time.” Its strong brand also gives Ralph Lauren the power to expand globally. The company’s The products sell in North America (48% of sales), Europe (28%) and Asia (21%). “Growth opportunities are good worldwide,” Royce says of Ralph Lauren’s prospects. “As the world continues to grow, they Will do well.” Global growth provides the long-term compounding in recurring revenue that Royce wants to see. Other long-term holds include Air Lease AL, -4.20% . The company owns aircraft from Boeing BA, -1.05% and Airbus EADSY, -2.39% buys and leases them to airlines. Air Lease supplies more than 200 airlines in nearly 70 countries. Makes a play on the growing middle-class in emerging-market countries. People travel more when they earn more. It’s also a play on long-term replacement cycles as airlines opt for more fuel-efficient, modern aircraft. Air Lease owns about 420 aircraft and plans to double the size by 2029 with the purchase of another 400 aircraft. This supports the long-term hold thesis. 3. Make friends with growth: Royce is basically a value manager but likes to add some growth stocks to boost returns. It doesn’t have to be white-hot growth – 10%-12% is fine. One example is Kennedy-Wilson Holdings KW, -6.35% , a real estate company that invests in multifamily and office properties in the US, UK and Ireland. The company uses its strong balance sheet and cash flow to find bargains in weak real estate markets. Wall Street analysts project 21% medium-term annual earnings growth for the company. Air lease is another example of a high growth opportunity. Sales rose 11% last year, and analysts forecast 26% medium-term annual revenue growth. Morningstar also fits the bill: Revenue grew 12.8% last year through the end of the third quarter. Ralph Lauren also qualifies. The company projects 2023 sales growth in the high single-digits. Analysts forecast 8.5% medium-term annual revenue growth. Here’s a bonus tip: Unlike many outperforming managers, Royce doesn’t get paid by taking focused portfolio bets that work. Instead, it tends to be fully diversified to reduce single-company risk. The largest position in his Royce Pennsylvania Mutual Fund, for example, is software company Agilysys AGYS, -3.34% , which represents less than 2% of the portfolio. In contrast, the top holdings in many mutual funds are 3% to 5% of positions. Michael Brush is a columnist for MarketWatch. At the time of publication, he owned META, AMZN, AAPL, NFLX, GOOGL and KW. Brush recommends META, AMZN, AAPL, NFLX, GOOGL, APAM, RL, KW and AGYS in his stock newsletter, Brush Up on Stocks. Follow him on Twitter @mbrushstocks More: If spoiled bank stocks seem attractive now, these buying tips can help you cash in plus: Buffett loves cash dividends and why you should too—plus 8 stocks with high yields to get you started.