Only a few US small-cap stocks are worth picking – but they produce outsized returns compared to the many ‘zombie’ companies in their universe, Eagle Asset Management’s Matt McGeary and Jason Wulff told a Funds Europe webinar.
Small-cap investing typically involves stocks that are more exposed to their domestic economies than their large-cap peers. Covid-19 has ravaged economies this year, but Matt McGeary, portfolio manager at US-based Eagle Asset Management, says certain small-caps are excelling as the American economy stabilises.
“They are differentiating themselves and demonstrating why their niche businesses are so valuable to us,” he says.
McGeary and his fellow portfolio manager Jason Wulff, share a fundamental belief in the long-term value of small-cap stocks as long as risk management is tight, and they say a risk-adjusted, low-volatility approach to small-caps gives investors the chance to diversify portfolios within a wider universe of stocks outside of the large-cap indices.
While Wulff and McGeary believe that the coronavirus downturn has in itself created investment opportunities in selected small-caps, there are longer-term structural trends at play that are likely to have an outsized impact on small-cap returns.
Firstly, most Western and developed economies have seen a slower economic growth rate due to ageing populations and falling birth rates. In turn, this has led monetary and fiscal authorities to pursue a compulsive stimulus model. For investors, this means long periods of subdued volatility followed by short periods of extreme and erratic volatility. It’s during these periods of dislocation where active managers can add value by having a bench of stocks available to invest in at a moment’s notice.
Secondly, passive investing and algorithmic trading are both on the rise, creating opportunities as the more “elastic” investors leave the market. A JP Morgan report from June 2019 estimated that passive products accounted for close to 60% of US equity assets under management, with quant strategies accounting for an additional 20%. This left discretionary and active mandates at just 20% of the market. The resulting herding into factor-based investing styles has driven a lot of the short-term market inefficiencies, which presents both risk and opportunities for investors.
Finally, a bifurcation is occurring in the small cap indices. To wit, loss-making companies now make up nearly 40% of the Russell 2000 Index and present a challenge for investors. Meanwhile, there’s a small, durable, and differentiated segment of the small-cap market which has had an outsized impact on returns over the years. Understanding these risks and opportunities is critical to success in the US small-cap asset class.
Economic policy responses
US small-cap stocks generally came away unscathed from the most recent market downturn, despite Q1 seeing the most rapid market declines in history, with small-caps affected by liquidity concerns. The massive Federal Reserve liquidity injection did create a bounce-back, but Wulff says the uncertain economic future, coupled with the large levels of debt at some companies, means the liquidity concerns will translate into solvency concerns.
Wulff told the webinar (held in June) that small-cap stocks were up by 42% since their March 18 lows. He said this reflected a steadier environment, but “solvency concerns still plague this asset class, so we are focused more on companies with stronger balance sheets and better long-term secular opportunities”.
It was during this period that unprecedented levels of stimulus were introduced to global economies, thanks in large part to global central banks. While this has subdued volatility in the near-term, the long-term consequences of such policies are unknown and will likely be a source of volatility for capital markets in the future. At face value, these policies are likely to place downward pressure on economic growth, creating opportunities for continued strength for asset-light business models.
“There will be winners and losers in this recovery and that is what we are focused on,” says McGeary. “Business models have fundamentally changed and successful companies have shifted their investments from physical assets to intangibles such as intellectual property and technology,” he adds.
“There may be some volatility to come from the latest round of economic and fiscal stimulus but as the economy normalises, and we get back to relatively slower growth models, we expect those asset-light companies to continue to be the likely beneficiaries.”
For example, companies that noticed the growth in cloud software five years ago and invested heavily in the technology have fared far better than those companies that invested in physical assets. One casualty of this trend is the car-rental firm Hertz, which is facing bankruptcy.
Small-cap indices’ structural changes
Easier access to private markets and increased regulatory scrutiny for publicly traded companies have led to fewer issuances from small-cap companies, the webinar audience heard. Consequently, in order for index providers to fill out these small-cap indices, companies further down the market cap spectrum, and oftentimes with less proven operating results, are included in these indices.
Said differently, there is a growing bifurcation between quality and so-called zombie companies within small-cap indices. The zombies, or non-earners, represent nearly 40% of the index. They can have a remarkably high impact on near-term index performance and drive wild volatility.
But, says Wulff, there is a subset of “great small-cap compounders” generating average annual returns of more than 20% over ten years. They drive the majority of overall market returns because, while they make up just 8% of the market index, they generate 45% of the index returns. Since these small-cap compounders get lumped in with lower-quality businesses in small-cap indices, the value of small caps, particularly on an idiosyncratic basis, gets lost in the shuffle, Wulff says.
In the midst of the current economic uncertainty, investors may ask why they would eschew the relative safety of mega-caps for the hidden gems of the small-cap universe. According to Wulff, less discovered companies that are generating greater value continue to produce investment opportunities, for the wider community as well as shareholders.
Many smaller companies tend to offer disruptive products and services that benefit society at large, and many management teams for these companies are more willing to engage in discussions with investors on ESG issues than their large-cap counterparts. It’s much easier to have a direct impact when working with smaller companies, says Wulff.
And while they may be harder to discover, there are enough of them, says McGeary. “The large-cap market tends to be dominated by a small number of mega-caps, but in the small-cap world, there are these interesting business models that have similar attributes in terms of intellectual property, intangible assets and network effect, but are less discovered and less concentrated than large-caps.” fe
The webinar – ‘A new regime: Opportunity for investing in durable US small-cap stocks’ – was presented in association with Eagle Asset Management, part of Carillon Towers Advisers. Visit www.funds-europe.com/webinars-channel.
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