Make these 9 investments now to capitalize on volatility and investor fears, according to a manager behind a top-7% fund in the last 15 years

• Small caps are often unloved by investors, which creates more opportunities for Brendan Hartman.
• The fund manager shared his investing strategy, which involves targeting four small-cap subgroups.
• Here are nine investments — including stocks, sectors, and industries — that Hartman loves now.

Investors frequently overlook smaller businesses. Brendan Hartman, a 28-year market veteran, understands why, but he believes the group’s case is seriously flawed.

By focusing on this underserved market, the co-manager of the Royce Small-Cap Opportunity Fund (RYPNX) has found success. Morningstar reports that the fund, which Hartman has managed since April 2021, has delivered a strong 10.1% return over the last 15 years, placing it in the top 7% of its category. It also wiped out its index in 2023.

There are numerous criticisms of small caps, but Hartman believes that none of them are sufficient to dismiss the group entirely. Smaller businesses are thought to be riskier because they are more vulnerable to economic fluctuations, and their small size can also make them more volatile.

However, those perceived flaws, according to Hartman, can be good reasons to invest in small caps.

“There’s a lot of volatility in small-cap and micro-cap markets,” Hartman recently told Insider. “Volatility does not frighten us if we can get the right price.” “The opportunistic value of this fund allows us to find appealing stocks regardless of the macro environment.”

Unlike large caps, which frequently trade in tandem, smaller companies are far from a monolith. Hartman told Insider that he prefers small-cap performance with a lot of variation over firms like Microsoft, which have no secrets left because they are heavily covered by analysts. When there isn’t a clear consensus on a company, Hartman looks for opportunities.

“With small micro-caps, oftentimes there’s only one or two analysts covering the company — maybe they’re not paying that much attention to it,” Hartman said. “So you can come in and find inefficiencies much more easily in that market than you can in large caps.” And, to be honest, it’s just more entertaining.”

More is more when it comes to small caps.

Several aspects of Hartman and his colleagues’ investing strategy distinguish the Royce Small-Cap Opportunity Fund from the competition.

First, Hartman stated that because small caps get less attention than large caps, he is able to meet with management teams running stocks in his fund on a regular basis. This access enables him to vet potential investments and determine whether the executives behind his current holdings have a viable business plan. In this case, he and his colleagues can establish relationships with management and provide feedback.

“In these small companies, it really matters who’s running it and how they’re running it,” Hartman said. “It’s not like these large corporations with their various divisions and systems.”

“These are much more hands-on type companies, and their customer relationships are very important,” Hartman stated. As a result, we spend a significant amount of time with management teams to ensure that the story remains consistent and unchanged.”

The fund’s “opportunistic” approach to small caps, according to Hartman, allows him to target four subgroups within the category: deep value, turnarounds and restructurings, undiscovered or underappreciated growth, and broken growth.

Each of those businesses has been sidetracked in some way. Perhaps they are vastly undervalued as a result of the industry and sector in which they operate, or they are undergoing an ambitious and risky transformation. It’s also possible that the market is undervaluing the company or has written it off unfairly.

“It gives us a pretty wide leeway to go and find value wherever we’re finding it,” Hartman said. “Maybe it’s a growthier market or more of a deeper-value market, but we’re not pigeonholed into owning a particular style of stocks.”

The number of stocks that can be held by the small-cap fund appears to be unlimited. At the end of the second quarter, Hartman’s fund held 251 stocks. Although having so many holdings diversifies a fund and reduces the impact of losing stocks, such a strategy also runs the risk of spreading assets too thin and diminishing the impact of winners.

“I don’t want to run the risk of having the right thesis and then getting the stock wrong,” Hartman explained when asked why his fund has so many holdings. Another advantage of having a large number of stocks is that it reduces volatility, allowing him to invest in boom-or-bust micro-caps.

9 top places to invest within small caps

Economists disagree on whether the US will enter a recession. While Hartman admits that small caps are cyclical and may fall in response to growth, he and his colleagues aren’t going defensive or selling stocks in the face of uncertainty.

“Our investors pay us to be invested and keep our foot on the gas, if you will, because if they want small-cap equity exposure, that means they want that market exposure,” Hartman said.

“We leave it up to the clients to say whether they’re bullish or bearish,” he said. They can also reduce their exposure to small caps if they become bearish and believe we are entering a recession. However, our portfolio is currently pro-cyclical.”

Small caps are currently more appealing than large caps, and value names are more appealing than growth names, according to Hartman. Despite the uncertainty in the investing environment, he believes that the lack of clarity and high interest rates favor active management.

Several market segments, including small caps in the industrials and technology sectors, stand out right now, according to Hartman. As of June 30, exactly half of Hartman’s fund’s assets were in one of those two categories, dwarfing the Russell 2000’s roughly 21% allocation.

While these two industries are distinct, Hartman observed some overlap. Companies in the middle can benefit from long-term growth from trends like reshoring, government infrastructure spending, and artificial intelligence.

“There’s a blending between these high-quality industrial businesses and technology because everybody’s using more and more technology in their processes, whether they’re automating production lines, whether they’re speeding up, using more data centers, putting more processes in the cloud, getting better ERP systems to run their business more efficiently,” Hartman said.

Hartman continued: “And we love to find these companies that are kind of going through a transformation and getting rid of lower-margin, lower-return-on-capital businesses and trying to upgrade their portfolio of businesses more towards some of these industrial tech applications.”

According to Hartman, investors can participate in the industrials sector by purchasing commercial aerospace stocks. The industry was hard hit during the pandemic and dealt with the fallout from Boeing’s problems, but according to the fund manager, airlines now can’t get enough planes for their fleets.

Hartman mentioned two off-the-radar ways to profit from the aircraft boom: Haynes International (HAYN), which produces temperature-resistant alloy sheets used in jet engines, and VSE Corp (VSEC), which supplies and repairs airplane parts. He is looking for CEOs from both companies who have significantly increased profitability by cutting costs.

Hartman also likes Modine Manufacturing (MOD) and Garrett Motion (GTX), two auto component suppliers.

Hartman’s largest holding is Modine, and the fund manager is pleased with how the company’s CEO has transformed it from a low-margin commercial truck company to a more profitable one. That shift resulted from a renewed emphasis on data centers, which are becoming increasingly important as internet demand grows at an exponential rate. When data centers heat up, Modine’s heat transfer systems help to keep them cool and operational.

Garrett Motion was spun off from Honeywell and has since gone off the rails, which Hartman attributes to its complicated financial structure. The stock is now extremely cheap because investors believe internal combustion engines will soon be obsolete, but the fund manager claims that its business is actually growing.

“It’s a classic case of nobody’s paying attention now, but they will be — hopefully — in the next six to nine months,” Hartman said.

According to Hartman, the CHIPS and Science Act, which was passed last summer, will benefit industrial stocks in the semiconductor capital equipment industry significantly. If geopolitical tensions rise, the US is scrambling to reduce its reliance on Chinese and Taiwanese chip manufacturers, and American firms will be well-positioned to benefit from that shifting capital.

Outside of industrials, Hartman is bullish on homebuilders because they are poised to see outsized demand. Property owners are hesitant to sell, even at high prices, due to sky-high mortgage rates, which, according to the fund manager, is driving homebuyers to purchase new homes instead.

“They’re building new homes, and they’re the only game in town as far as supply goes,” Hartman said.