Small cap stocks flourish under the radar

“I’d like to know who actually came up with that ridiculous phrase risk-on, risk-off,” asks Chuck Royce, president and co-chief investment officer of Royce Funds, which specialises in small cap stocks.

We had been invited by Legg Mason for cocktails at the Mandarin Oriental hotel in New York. Legg Mason (famous for its manager Bill Miller who beat the S&P 500 for a straight 15 years until 2005) owns a diverse collection of asset management firms, in an eclectic federation representing unrelated strategies, approaches and outlooks. Royce, for instance is optimistic on equity markets in 2012, believing the American small cap market bottomed in 2011 and this year’s movement will be “positive”.

It is understandable that small cap managers might decry risk-on risk-off strategies, which basically lump the good, the bad and the ugly together as a reflection of increased correlations among global asset classes. Smaller companies’ prices get sucked along with the tsunami, and are denied the specialised attention they merit. During bullish periods, these higher-beta names tend to outperform larger, more mature behemoths; on the downside small caps exhibit higher volatility. This chart compares the small cap Russell 2000 last year to the Russell 3000 overall market. (blog continues below)

I asked Royce Funds portfolio manager Frank Gannon how his funds manage to finesse such volatility.  The key, he explained, is to take advantage of the roller coaster, by understanding the companies well enough to invest more cheaply during dips, and then hang on patiently – applying consistency, discipline and long-term horizons.  Technology and consumer non-durables are popular sectors. How about dividends, which have become such stars on today’s low yield environment? Gannon hastened to assure me that many of their small cap holdings paid out in a 2 to 3% range, more generously than one might imagine from smaller fry.

Incidentally, who did in fact coin that hackneyed risk-on risk-off catch phrase. Of course assets have been increasingly correlated for several decades now, leading up to the highs of 2008.

It turns out the expression may have been first publicised by David Bloom and his forex team at HSBC in the summer of 2010.