Small-cap value stocks rank among the market’s riskiest fare.
But higher risk can bring bigger rewards, and in the first quarter, it did for three of the better-performing mutual funds. Each returned more than 20 percent by betting on small-cap value.
Value investors are betting on stocks that they think are trading below their fundamental worth. Often, companies end up classified this way because they operate in out-of-favor industries or have had setbacks.
Here are some of the choices that enabled three funds to prosper.
Kinetics Small-Cap Opportunities
The Kinetics Small-Cap Opportunities Fund toted up a first quarter return that would have been whopping for an entire year — 60.5 percent. In contrast, the S&P 500 index gave a total return of 6.2 percent for the quarter.
Peter Doyle, one of the fund’s co-managers, said his fund achieved its result thanks to an unusual holding: the Texas Pacific Land Corporation.
Permian Basin, one of the United States’ leading oil-and-gas-producing locales. The company earns royalties from others’ drilling on its land, and its stock shot up in the first quarter, returning nearly 120 percent.
Until this year, some mutual funds wouldn’t hold Texas Pacific because it was a publicly traded trust, not a corporation. It converted its legal structure in January, though Kinetics has owned it since about 2013.
Texas Pacific recently accounted for 43.9 percent of the fund’s assets. It was one of 36 holdings.
Kinetics’s enormous bet is “an outgrowth of our long time horizon and low turnover strategy,” Mr. Doyle said. “Maybe five of our names will be great investments. If you don’t turn over frequently, those five will become a bigger and bigger percentage of the portfolio.”
Mr. Doyle said patience is essential to how he and his co-managers run their fund. He said they view it as an advantage in a business characterized by shorter-term thinking.
Fund managers’ bonuses are often based on annual returns, so they focus on those, he said. “If you can get away from that, you can buy great companies at a discount.”
Hartford Small Cap Value Fund, sleuths for values, too. But unlike Mr. Doyle, he shies from the energy sector.
Today in Business
He said that’s an outgrowth of his approach, which focuses on companies’ ability to produce free cash flow — that is, cash left over after a company funds its operations and maintains its assets. (Small-cap energy businesses can be speculative and require substantial investment before producing free cash.)
To spot cash spigots, Mr. Kammann ranks the 900 stocks in his investment universe and digs deeper into the better-ranking ones to understand why they’re cheap.