Hedge Funds Pick Up Small-Cap Stocks in Bet on Economic Recovery

(Bloomberg) -- Some hedge funds are favoring small-cap stocks as the battered U.S. economy shows early signs of a recovery.

Hedge funds and other large speculators have trimmed their bearish bets on small-caps since April, with net long positions in the Russell 2000 futures recently hitting a three-month high, data compiled by CFTC showed. Among the firms snapping up such equities are Intrinsic Edge Capital Management and Roubaix Capital.

“The message of almost every company in every industry is we’ve come off the bottom, their businesses are improving on a week-to-week basis and we’re seeing continued growth across housing, retail, casinos, etc.,” Mark Coe, Intrinsic’s founder, said in a telephone interview.

Small-caps have been on a tear since May as lockdown restrictions spurred by the coronavirus began to ease. A surprise positive jobs report on June 5 is further fueling expectations that the economy is on the mend. Some investing heavyweights including Stan Druckenmiller have lamented that they were too cautious as the broader stock market rally gained momentum.

The Russell 2000 Index has advanced for three straight weeks and has gained 17% since mid-May while the S&P 500 index is up 11%. While the small-cap index trails the broader market this year, if investors think the economy is improving large-cap equities may lose their appeal, according to Christopher Hillary, chief executive officer and portfolio manager at Roubaix Capital.

“Small-caps stand to benefit as they have the highest leverage to an improving U.S. economy,” Hillary said. “As the economy normalizes, particularly the large-cap tech stocks, which are the new defensives, are going to be less attractive.”

That explains why Intrinsic and Roubaix are favoring small-caps. Coe, who founded Chicago-based Intrinsic in 1999, said he’s the most bullish since the fund started. After coming into the year with a more bearish view of U.S. stocks, Hillary is now the most optimistic he has been on small-caps in seven years.

While small-caps have finally joined what is now the fastest ever rebound from a bear market, they’re still lagging behind the megacaps with piles of cash and solid balance sheets that started the rally from the March lows. The Nasdaq 100 is up 16% this year through Wednesday, the S&P 500 is down 1.3% and the Russell 2000 has declined 12%.

Yet even if the sentiment on small-caps is positive, the sector could be hurt, particularly if the economy stalls or the pandemic fails to abate. On Wednesday, the Federal Reserve said the economy faces “considerable risks” over the medium term Chair Jay Powell said the labor market would take time to heal.

Coe’s $700 million firm is seeing opportunities in several areas including recreational vehicles and data centers, the latter of which has benefited from an increased demand for bandwidth as people work from home.

After covering several of his short positions, Hillary of Denver-based Roubaix said he began adding to long exposures in April, including buying stocks in more economically sensitive sectors that have underperformed and thinks will recover, such as elective health care and consumer-related industrials.

Fertility benefits manager Progyny Inc. and TransMedics Group Inc., which operates in the organ transplant market, are among the firm’s health-care investments. While both stocks are down this year through June 10, they are up since the market’s March low with Progyny gaining 50% and TransMedics up 6.6%.

Roubaix also invested in Orion Engineered Carbons SA, the maker of materials for ink, polymers and tires; Rogers Corp., which is involved in areas such as base stations and radar and car sensors; and EnerSys, the Reading, Pennsylvania-based maker and distributor of industrial batteries.

Roubaix’s $90 million fund is up almost 12% this year through May, with the bulk of the gains seen in April and May, according to an investor letter obtained by Bloomberg. Hillary declined to comment on the firm’s performance.

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