The American money manager betting on small stocks over blue chips

The companies in Small-Cap Total Return average a market value a thousandfold smaller than that of Apple. They are cheap, too, trading at a collective 13 times trailing earnings, to 21 for the S&P (both calculations omit companies losing money). 

It would be better for Lewis if his stocks weren’t quite so cheap. Like most of what’s in the Royce lineup, his fund can, net of its 1.2 percent annual fee, boast of benchmark-beating returns since inception (for this fund, in 1993). But that’s not good enough. When investors compare the results not to an index of small value stocks but to the S&P 500 they feel they’re missing out. In every year of the past decade, Morningstar reports, Royce mutual funds have seen more assets depart than arrive. 

It’s normal, Lewis says, for big stocks to enjoy a decade or so of outperformance, followed by a decade of reversal. But the current tilt to big growth is at a statistical extreme. Calculate this ratio: The collective value of the market’s five most valuable companies (Microsoft, Apple, et cetera) to the collective value of the 2,000 companies in the Russell 2000. A decade ago that ratio hovered just above 1 to 1. Now it’s just shy of 5 to 1. 

Perhaps this will be the year when the little stocks break the spell. A disruption in inter­national trade can’t be good for Apple, given its entanglement with China in both manufacturing and sales. It shouldn’t bother UFP Industries, a Michigan firm and Lewis pick that makes pallets for domestic factories.

Anti-American sentiment won’t hurt International General Insurance Holdings. This obscure Jordanian company underwrites weird risks in weird places (recent claim: Loss from cancellation of a rock concert in Venice after the lead singer inhaled smoke from a fire at a gig in Paris). International General is the fund’s largest holding.

Also read: The Jane Street Saga: Will retail activity take a hit?

There is a plausible story and, so far, some wishful thinking behind Academy Sports & Outdoors. This retail chain is a poor man’s Dick’s Sporting Goods. Lewis figures that a weak economy and tariff-driven price increases at both companies will force shoppers to trade down. His position is underwater but he’s hanging on. The case for this contrarian bet is all the stronger now that Academy’s price-to-earnings multiple is half that of Dick’s. 

Value investors prefer companies trading at low multiples of earnings or net worth. Alas, cheap stocks have flaws. Lewis holds Advance Auto Parts, which looks pathetic alongside AutoZone. They both may have to raise prices to cope with tariffs but they both will probably benefit as impecunious drivers keep clunkers on the road. Auto­Zone coins money. Advance is in the red. The flawed retailer is priced, in relation to revenue, at a tenth of AutoZone. Lewis describes it as “a bad house on a great block”. Somebody will fix it up. 

The flaw at Hingham Institution for Savings, founded in 1834, is its outmoded business model of borrowing short (with deposits) and lending long (commercial mortgages). When the yield curve inverted two years ago, earnings tanked, the stock crashed and Lewis got in. He was willing to overlook the earnings blip. The family running this bank has boosted its book value per share 27-fold in 32 years. 

Assured Guaranty is in the business of backstopping disappointingly rated issues of munici­pal bonds that would otherwise have trouble finding buyers. Its flaw is a subpar return on equity, and Wall Street punishes the company with a share price 23 percent below book value. The insurer has turned that problem into a benefit by using its ample cash flow to repurchase stock at below book. “It’s a share cannibal,” Lewis says. Assured has, in the past decade, cut shares outstanding by 63 percent and increased book value per share by 152 percent. 

The bond insurance play takes Lewis full circle. After graduating from William & Mary College he went to work at MBIA, the biggest bond insurer at the time. His job, which took him back to his native New Orleans, was working out problems at municipal entities distressed by Hurricane Katrina. Soon enough MBIA was itself in distress. Its stock collapsed 97 percent. 

Lewis, now 46, escaped to get a business degree at Cornell and took a job researching small-company stocks for American Century, starting in Kansas City, Missouri. A winning record at that fund vendor landed him a job five years ago in Manhattan at Royce Investment Partners, now majority-owned by Franklin Templeton. (Founder Charles Royce, 85, stopped managing money but remains a kibitzer.) 

Besides the dry spell in small value stocks, Lewis and his colleagues have this to contend with: Index funds are now the rage. He concedes that passive investing is hard to beat in large-cap investing. How easy is it to outsmart the market on Apple, when 53 analysts cover it? But he is not willing to give any ground to indexers with a stock like Hingham, which has zero analyst coverage. Speaking for the remnants of active management in small cap, he says: “We’re the last man standing.”