Small-cap managers' picks crushed these indexes last year

Those, at least, are the investments currently favored by Palm Valley Capital Fund PVCMX — perhaps the best penny stock picker you've never heard of.

Palm Valley principals Jamie Wiggins and Eric Cinnamond have accomplished the difficult feat of beating the Russell 2000 RUT and S&P 600 SML small-cap indices over the past several years — while not investing in stocks at all.

Later.

Palm Valley Capital held just 20% of its portfolio in stocks for most of last year — as it did in 2022, 2021 and 2020. The rest of the money was held in short-term Treasury bonds. In 2019, the year the fund was launched, the portfolio's share of the stock market was typically 10%. or less.

Nuts? certainly.

excludes…

During that period, the few small-cap stocks the fund owned drove the market out of the market. Last year, the fund's shares gained 33%, twice the return of the small-cap indexes. In 2022, a disastrous year for markets overall, Palm Valley stocks gained 13%, while small-cap indexes fell 15% or more. In 2020, the fund's shares gained 25%, far outperforming the indexes.

The fund charges a fee of 1.3% annually for common stocks, and 1% for those wishing to invest $500,000 or more. As of June last year, the fund had $221 million in assets.

Whether you want to take Palm Valley's ultra-cautious approach, and hold on to a lot of cash until you find great investments, is another question. The fund is what is called an absolute return fund, meaning that it values ​​return on equity more than return on equity. This is the main reason why she keeps so much money.

These days, rightly or wrongly, conventional wisdom on Wall Street advises separating the roles of asset allocation and stock picking. First you need to decide how much money you want in the stock market. You then invest that money, generally via low-cost index funds. The absolute return strategy, where someone combines the two roles, is a very old strategy.

But there's no arguing with the stock-picking skills of these managers over their nearly five years running this mutual fund. Overall, although the fund remains mostly on margin in Treasuries, it has still generated a total return of 41% since its April 2019 launch.

The broad small-cap Russell 2000 index, as tracked by the low-cost iShares Russell 2000 ETF IWM.,
It rose by 31% during the same period.

The regular index exposed investors to much greater risk. That included double-digit swoon last year, when Palm Valley's maximum decline was about 1%, and a 30% collapse during the Covid scare in March 2020, when Palm Valley fell about 5%.

The 12 names listed at the beginning of this article make up the fund's 10 largest holdings at the start of this year – led by the Silver Fund – as well as the two stocks it recently started buying.

Wall Street has been bracing for small caps lately. According to the latest BofA Securities survey, money managers are more bullish on small caps than they have been in several years.

The argument in favor of small caps is that they offer higher returns than large-cap stocks, albeit with much greater volatility. That's why investors are often advised to allocate a small portion of their 401(k), IRA, or other retirement account to a small-cap fund.

Whether this argument is valid is another matter. As Palm Valley Capital's performance suggests, smaller companies may be attractive for a very different reason: because they offer more opportunities for stock pickers.

Meanwhile, Wiggins and Cinnamond caution against being too optimistic about penny stocks in general. They write that stocks in small-cap indices are not as cheap on average as they seem at first glance.

the reason? Stocks that look cheap are often low-quality junk. Before the 2008 financial crisis, about 20% of companies in the Russell 2000 index were unprofitable, they recall, but “today, it's 40%.”

They calculate that the average net income of companies included in the index is about the same as it was in 1998, a quarter century ago, or less. This is in nominal dollars – in other words, before inflation.

Meanwhile, high-quality profitable stocks in the Russell 2000 have largely kept pace with large-cap stocks. Over the past few years, “the returns of small companies have not differed significantly from those of large companies when they strip out risk,” Wiggins and Cinnamond write. “Most quality small businesses never get cheap, in our opinion.”

And again, if someone kept 80% of their money in Treasuries, would you expect them to say anything different?