Fund manager Q&A: Spotlight on investing in small-cap funds

This undated photo provided by Aberdeen Asset Management shows Ralph Bassett, portfolio manager for the Aberdeen U.S. Small Cap Fund. In an interview with The Associated Press, Bassett makes the case for why small company stocks are poised for a turnaround, after a weak start to 2017. (Courtesy of Aberdeen Asset Management via AP)

Stocks in smaller companies trounced the broader market last year, especially in the weeks after the presidential election. So far this year, though, it's been a different story.

The Russell 2000 index of small-company stocks is at about breakeven for this year after vaulting 19.5 percent in 2016. By comparison, the Standard & Poor's 500 index is up 5 percent. Other major stock indexes have also notched gains this year.

Investors bid up small-company stocks on the belief that the companies would benefit more from an improving U.S. economy and promises of tax cuts, deregulation and other policies championed by the incoming Donald Trump administration. Lately, though, doubts over when key aspects of Trump's agenda will be enacted have begun to weigh on small-company stocks.

Ralph Bassett, portfolio manager of Aberdeen Asset Management's Aberdeen U.S. Small Cap Fund (GSXAX), makes the case for why small-company stocks remain fairly valued. But he also favors a wait-and-see approach until there's more clarity out of Washington.

The fund is down about 4 percent this year, but up 15.8 percent from a year ago, according to Morningstar.

Answers have been edited for length and clarity:

Q: Why are smaller company stocks lagging the rest of the market this year?

A: Part of the reason we've seen maybe a bit of underperformance more recently has been the fact that the market ran up quite strongly last year, particularly in the third quarter and then ultimately postelection. We think that on a relative basis we've just seen some underperformance after that outperformance. Also, there might be less optimism around some of the pro-growth proposals being enacted this year.

To see further propulsion in the market we're going to need to see some of those (policy) issues come into play.

Q: What is your fund's biggest holding?

A: As of December, our largest overweight to the index was in industrials. Our largest holding was Beacon Roofing Supply.

Q: Investors' expectations of business-friendly policies from Washington helped boost small-cap stocks. Are there any policy proposals that could be a negative on smaller companies?

A: Trade would be one thing. Even though they're pretty domestic, small-cap companies do source a lot of materials externally, especially parts they would use for assembly. A lot of our companies use Mexico, China, common places that have been voiced as concerns in terms of how they're viewed as trading partners with the U.S. So that would be certainly a risk, if there were to be some sort of border tax system.

The other thing is interest tax deductibility. A lot of smaller companies are in the consolidation phase and they do often times use leverage to fund that. If companies were to, on a go-forward basis, not be able to deduct that interest, it would cause some concern for businesses that are funding acquisitions at the moment.

Q: Is now a good time to buy small-cap stocks?

A: We think it's a good time to start looking. We are never great timers of asset classes, and I'm saying that as a manager. It's very hard with any precision, but anyone with a longer term investment horizon should certainly start looking now — especially from where we came from, postelection at the end of the year — at valuations of small versus large.

We feel more confident or comforted with where small caps are trading on a relative basis to the S&P 500 today, given the underlying prospects that we see.

If you take the Russell 2000 and look at those companies that are forecast to have positive earnings, the consensus expectation is still for double-digit returns this year in terms of earnings growth.

So, even absent multiple expansion or anything that would cause markets to revert higher, we still think that underlying earnings growth remains reasonably healthy. And what we see in terms of the proposals being put out there should only help to support that in coming years.

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