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Aug. 19, 2017, 10:42 a.m. EDT

This fund manager finds contrarian bargains among ‘smidcaps’

Westwood SmallCap Fund favors consumer-oriented names, energy

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By Michael Brush, MarketWatch

MarketWatch photo illustration/Getty Images, Bloomberg

Pity the poor small-cap investor.

Large-cap names have been ripping higher, pushing the S&P 500 /zigman2/quotes/210599714/realtime SPX +0.89%   up 10% so far this year and leaving small and midcap stocks in the dust. The Russell 2000 /zigman2/quotes/210598147/delayed RUT +1.98%   is only up about 2%.

This tells me that “smidcap” land is a good place to look for relative value and contrarian bargains in what otherwise looks like a fully priced market.

Who better to turn to for some guidance here than a fund manager with a great record in the space: Matt Lockridge of the $213 million Westwood SmallCap Fund /zigman2/quotes/200841600/realtime WHGSX -0.93% . At a time when around 80% of active managers sorely underperform benchmarks, his funds beats its competitors — small-cap blend funds tracked by Morningstar — by 2.2 and 3.4 percentage points annualized over the past three and five years, respectively, according to Morningstar.

But first, does it even make sense to think that smidcap stocks can make a comeback? Lockridge has a bias, of course, but he offers a compelling case.

Both large-cap and smidcap names recently traded for the same valuation, or 17.4 times forward earnings, using the S&P 500 and the S&P 400 as proxies for each group. But smidcap stocks have a higher projected annual earnings growth rate — 12.6% compared to 11%. “That alone should start attracting interest in the small caps,” says Lockridge.

Smidcaps will also get a bigger boost from any tax reform that lowers the corporate rate (as promised by President Trump), since they generally pay higher taxes. Plus if inflation picks up, that will help smaller companies because they tend to run leaner. So more of the revenue gain drops to the bottom line.

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So where’s the best value in smidcap land? Lockridge’s fund is overweight consumer-oriented names, energy, and the basics like industrials and materials. It’s underweight utilities and financials, though it did add a bank in the second quarter, a Mississippi-based regional lender called Renasant /zigman2/quotes/200892803/composite RNST +2.53% .

Why this skew? “Our portfolio is a snapshot of where our analysts are collectively finding value,” he says.

Here’s a quick guide to a few of the fund’s longer-term holdings that Lockridge thinks will recover from recent selloffs as well as to fresh positions added in the second quarter.

Sidestepping the ‘Amazon effect’

Chains like Macy’s /zigman2/quotes/201854387/composite M +0.77% , Target /zigman2/quotes/207799045/composite TGT +1.42% , Dick’s Sporting Goods /zigman2/quotes/200566298/composite DKS +2.47% , and J.C. Penney  have been slammed due to the “Amazon.com (AMZN) effect.” The online juggernaut is steamrolling these old-school retailers.

But Lockridge and his team aren’t adding any beaten-down brick and mortar names. “There may be opportunity for a bounceback trade. But longer term, it is a difficult place to invest,” he says. “Amazon is arguably the most disruptive company in my lifetime. There is a secular change going on.”

Read: These two companies are the biggest disrupters of our age

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