Now that low interest rates and a sluggish economy seem to have insinuated themselves into a state of apparent semi-permanence, investors and their advisors may as well figure out how to take advantage of them rather than biding time until they magically disappear. Of course, that's a trick not easily done, but there are several reasons to think that at least one asset class can pull it off: small-cap value stocks.
Low interest rates benefit small caps in several ways: besides reducing their borrowing costs and making stocks in general more attractive, low interest rates also make it more enticing for larger companies to make acquisitions, and those larger companies often target smaller companies that fill market niches or offer promising technologies. Acquisitions are even more attractive during times of sluggish growth, since they offer one of the few ways to boost revenues. The value side of the small- cap market is particularly attractive, because those companies are cheaper relative to their earnings, making them more attractive acquisition targets.
Merger and acquisition activity slumped during the recession that began in 2008, but appears to be reviving now. Standard & Poor's 500 companies are sitting on "an unprecedented level" of spendable cash "permitting them for the first time in memory to undertake multi-actions simultaneously," says Howard Silverblatt, senior index analyst for S&P Indices. (S&P Indices operates independently from S&P Equity Research.) Deal activity has been heating up lately, including the first hostile offers in recent memory, and more deals are on the way: a survey released in September 2010 by Merrill Datasite of 119 large-cap companies found that 51% expect to make an acquisition in the second half of 2010. A strong majority, 71%, of those expect to buy smaller companies costing less than $500 million, because they will drive revenue growth without much increase in risk. Activity will pick up further in 2011, 72% of respondents said.
There are well over 100 mutual funds that invest in U.S. small-cap value stocks. To identify the most attractive, we screened for funds that are open to new shareholders, have assets of $20 million or more, no sales load, and a five-star ranking from S&P. Just seven funds passed that screen, and of those, we chose three that offered a combination of strong historical performance over three- and five-year periods as well as below-average cost.
The Big Performers Among the Small Caps
No. 1: Heartland Value Plus. Of the three small-cap value funds meeting those criteria, the largest and best performing fund is the $1 billion Heartland Value Plus Fund (HRVIX), which boasts the second-best five-year performance–5.63% annually–among all small-cap value funds as of Sept. 16, 2010, and the third-best three-year performance of 1.51%. Since it opened in October 1993, it returned an average 10.21% annually, according to Lipper data.
