A small-cap fund guru explains why you need to invest in smaller companies: They’re the stock market’s undiscovered nuggets.

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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 reported 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 who has 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. Now investors can choose from over 500 small-cap funds and over 100 small-cap Exchange Traded Funds (ETFs).

Royce not only brings wisdom gained from more than five decades of investing, but he also has a strong track record that supports his approach. His Royce Pennsylvania Mutual Fund PENNX,
Beat its Morningstar US Small Cap Index by 1.5 and two percentage points annually over the past three and five years.

Here are Royce’s three key moves on the stock market, the strategy that helped him outperform, and some of his favorite small-cap names to consider.

1. Shine in small caps Royce agrees with a Bank of America strategist that small-caps are cheap. But he uses a slightly different logic. He expects small caps to do better as they did so badly last year.

The three- and five-year returns for small-caps in the second half of 2022 come in at around 4%-6%. This is predictable, as it was below the group’s long-term average of about 10% since 1978. Historically, periods of below-average returns are followed by nearly 100% solid performance, Royce says. “We are confident that the valuations are absolutely in place,” he added. “We think the stage is set for the asset class to retake market leadership from large caps.”

2. Small-caps will beat the “FAANGs”: The low interest rate environment of the past several years has favored companies that depend on earnings in the distant future. Discounting the low rates currently in those distant earnings looked huge. This is no longer true, now that rates are higher.

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This change will hinder the performance of the “FAANGs”: Meta Platforms Meta,
, Amazon.com AMZN,
, apple aapl,
, netflix nflx,
and the alphabet GOOGLE,
Royce says small caps will take over the market. “The underperformance of small caps relative to FAANGs was exceptional,” he says. “It has established an absolute and relative valuation advantage.”

, ‘Entry points should be slow and well thought out. You want a large average price.’ ,

3. Don’t Worry Too Much About “Retest”: One debate now is whether the market will retest the October 2022 low. “I don’t think it’s very important,” says Royce. “I know we’re in the 8th or 9th inning of this decline.”

There’s no need to time your purchases exactly right, he says, for two reasons:

First, he observes that small caps have an excellent multi-year period ahead, so you should do fine even if you don’t buy exactly at the bottom. Next, when entering positions, forget about the “right” price, he says. “A lot of portfolio managers think they have to buy a stock at $12, so if a stock is at $13, they’re not going to buy it. Ultimately it’s the average price you pay that counts.” Entry points should be slow and well thought out. You want a large average price.

stay small

Here are three investing strategies that Royce says contributed to his performance, and five stocks he’s picked now, plus one bonus name:

1. Focus on Quality: In addition to favorable valuations, Royce likes to see quality. “Quality” is a subjective concept in investing. But for Royce it boils down to finding a sustainable and sustainable advantage. This can mean companies with a strong brand, strong reputation, recurring revenue or pricing power. Evidence of quality is also visible in metrics including improved return on capital, free cash flow and dividends.

An example is Artisan Partners Asset Management APAM,
An investment company with approximately $138 billion under management. Royce places it in the quality camp because of its great reputation based on its management and investment returns. They also like that it’s “asset-light,” meaning it doesn’t require a lot of capital expenditure. Hence free cash flow is high. Royce expects the share price to double in the next three to five years.

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Another example is Morningstar Morning,
Which provides analysis, data, independent research and wealth management services to investors. Subscriptions, licensing and money management generate substantial recurring revenue. It contributes to the quality of business. “They’ve evolved in the most fascinating way over the last 15-20 years from just mutual fund ratings to various activities in publishing and wealth management,” says Royce. “They’ve done an extraordinary job of accruing customers and reinvesting income, which is important.”

2. Think Long Term: Royce prefers to be in what he calls a long-term compounder. “I’d like to think I can own a company forever,” he says. “That thinking was not clear to me 30 or 40 years ago, and it is not clear to the market most of the time. But we are comfortable holding stocks for 10 years or more.

He says this gives him an advantage in an investing world where so many people focus on the short term. The only position he can comfortably hold for the next 10 years, he says, is apparel, footwear and accessories company Ralph Lauren RL.
Its strong brand puts Ralph Lauren in the quality camp. Says Royce: “It’s an exception to the story that most brands fade away over time.”

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 growth opportunities are good around the world,” says Royce about Ralph Lauren’s prospects. “As the world continues to grow, they will do well.” Global growth provides the long-term compounding recurring income that Royce seeks to see.

Another long term hold name is Air Lease AL,
The company buys aircraft from Boeing BA,
and Airbus EADSY,
and leases them to airlines. Air Lease supplies over 200 airlines in approximately 70 countries. This makes it a play on the growing middle class in emerging market countries. People travel more when they earn more. It’s also a play on the longer replacement cycle as airlines choose more -efficient, modern aircraft. Air Lease has around 420 aircraft and plans to double its size by 2029 with the purchase of another 400 aircraft. This supports the long-term holding thesis.

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3. Befriend Growth: Royce is fundamentally a value manager but he likes to add some growth stocks to enhance returns. It shouldn’t be white-hot growth – 10%-12% is fine.

An example is Kennedy-Wilson Holdings KW,
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 be a bargain in weak real estate markets. Wall Street analysts forecast 21% medium-term annual earnings growth for the company.

Another example of a high growth opportunity is air leasing. Sales grew 11% last year, and analysts forecast 26% medium-term annual earnings growth. Morningstar fits the bill, too: It posted a 12.8% increase in revenue through the end of the third quarter last year. Ralph Lauren also qualifies. The company forecasts sales growth in the high single digits. Analysts forecast medium-term annual earnings growth of 8.5%.

Here’s a bonus tip: Unlike a lot of outperforming managers, Royce doesn’t get returns from making concentrated portfolio bets. Instead, he tends to remain fully diversified to reduce single-company risk. For example, the largest position in his Royce Pennsylvania Mutual Fund is in software company Agilysys AGYS.
Which represents less than 2% of the portfolio. In contrast, the top holding in many mutual funds is 3% to 5%.

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

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