The Golden Mean? Looking at SMid-Caps

Steven McBoyle

An Established History

With a history of close to four decades as disciplined value investors, we like to think that we have established significant expertise in the evaluation and management of small-cap portfolios. Our firm's deep institutional knowledge and time-tested historical approach to this evergreen asset class have been two of the defining competitive advantages that we believe we enjoy in the marketplace.

One of the core premises in small-cap investing is the idea that looking where other investors don't offers distinct advantages. Smaller companies on average have higher growth prospects, less sensitivity to general economic trends and are often more self-determinant of their success or failure than larger, more established businesses. Other factors that also make this segment a potentially rich universe for disciplined investors include at times scant institutional research coverage, liquidity and trading complexities, and higher tactical allocation biases among investors.

Investing in Micro-Caps and Small-Caps

Starting with the micro-cap segment of the market, where life begins for a multitude of businesses, Royce's investment process has benefited enormously from looking at companies early and following them closely through their life cycles as businesses. Corporate success and share-price growth generally lead to progress up the market capitalization spectrum and with it greater acceptance and exposure to a broader group of investors.

This next investment tier up we define simply as small-caps. It has become an accepted and desired allocation in most investment portfolios. However, small-caps also have historical impediments to being scaled more aggressively in investor portfolios. By definition, they are smaller and therefore less liquid than their large-cap counterparts. They tend to be more fragile and less diversified businesses that therefore generate higher share price volatility. Access to capital in order to finance operations, especially in recently challenging times, is often harder to obtain. Buy/sell spreads and transaction costs tend to be higher. Institutional resources, such as research and investment banking, are less abundant. All of these considerations work to keep small-cap allocations more modest than they might otherwise be given their attractive absolute and relative return profile.

New Opportunities

One interesting alternative to the typical combination of small-cap and large-cap allocations exists somewhere in between, lying in an often-underappreciated zone of the equity market. We think that the smid-cap–small-cap to mid-cap–universe combines many of the attractive performance attributes of the small-cap segment with some of the liquidity and business stability characteristics more traditionally associated with larger enterprises.

Interestingly, as small-cap has become an established asset class, the companies trading closest to the periphery have become somewhat orphaned, and therein lies the opportunity. In fact, a spirited internal debate among our portfolio managers has always taken place about how best to treat the legacy of information and expertise developed for those businesses that have moved far out of our traditional capitalization parameters, that is, above $2.5 billion in market cap.

SMid-cap portfolios therefore represent a logical extension of Royce's core research capabilities in the small-cap universe, allowing us ongoing use of our institutional knowledge as companies we know well move up (and down) the cap spectrum.

An Emerging Asset Class

Defining and studying the SMid cap asset class is not yet a precise science, however. Most smid-cap investors measure their relative performance against the Russell 2500. Comprised of the entire membership of the Russell 2000–the broadly accepted small-cap benchmark–and the smallest 500 companies within the Russell Midcap Index, the Russell 2500 index offers fair representation of the pool of small-cap and mid-cap stocks that make up the smid-cap universe. Examining its performance characteristics over time gives a clear case for the opportunity offered by the smid-cap space.

Since the inception of these two indexes in 1979 through December 31, 2010, the Russell 2500 has consistently outperformed the Russell 2000. Using standard deviation to measure volatility, the Russell 2500 has enjoyed another advantage over its strictly small-cap counterpart—the volatility of the smid-cap index has been quantifiably lower than small-cap. We think that higher returns combined with lower standard deviation makes a compelling aggregate risk-reward profile.

The emerging acceptance of small-cap stocks as a permanent part of an investor's portfolio, combined with the traditionally dominant allocation to large-cap stocks, has created a meaningful investment opportunity in those stocks that fall in between. Smid-cap managers have a larger selection universe, with strong historical performance characteristics, lower volatility and greater liquidity than small-cap, while also boasting greater financial resources and business stability.

Our own work in this area includes two newer portfolios that recently marked their third anniversaries. We launched Royce SMid-Cap Value Fund and Royce SMid-Cap Select Fund in September 2007 to capitalize on our knowledge of those companies just beyond the upper boundary of our core selection universe. A natural extension of our core business, each Fund seeks to capture the inefficiencies that this singular segment of the market produces. Steven McBoyle and Whitney George co-manage Royce SMid-Cap Value Fund, while Steven manages Royce SMid-Cap Select Fund with Chuck Royce serving as assistant portfolio manager. The latter Fund is available only to Qualified Investors.