K.I.S.S. – Keeping it Simple in Smaller Caps

 KEY TAKEAWAYS:

• Rising cost of capital was the name of the game in 2022.  The operating environment for businesses is becoming more difficult.  
• Market leadership has shifted away from growth, large-cap, and passive.  
• Keep it simple – A bias to action and a preference towards the obscure (and usually more expensive) is not necessary for investors to generate alpha.  
• Seek an active approach – smaller cap indices and passive vehicles have a high percentage of companies that make no money – a difficult backdrop for those businesses as cost of capital rises.

    

Portfolio Manager:

We’re constantly trying to get our clients in front of companies that we think can prosper under different types of business conditions. Whether those are fairly ebullient as you’ve had over the last number of years or whether they’re more challenging as certain companies have started to experience now with the emerging cost of capital, the idea is to not predict what sort of business conditions those companies will face, but rather get attached to them at attractive price points where there is an outsize return potential to the extent they’re able to navigate whatever the future holds.

Kyle Helton:

Hello and welcome to the QPD Podcast and our first episode of 2023. I’m your host, Kyle Helton, Senior Vice President and Regional Director of our West Coast Advisory Group. On today’s show we have Portfolio Managers of the Small and SMID Value portfolios at Cambiar. Today we’ll discuss how they were able to navigate a volatile 2022, 2023 outlook, and portfolio positioning, as well as what could be in store for the small and mid-cap asset classes in this upcoming year. I’m excited to have them back so let’s get started. Gentlemen, welcome back to the show.

Portfolio Manager:

Hi, Kyle.

Colin Dunn:

Hey, Kyle.

Kyle Helton:

To briefly reflect on this past year, you both have spoken extensively about the anticipated market correction that would ensue once the Fed began to taper. You’ve positioned both your portfolios to handle this situation quite well. Was there anything that surprised you about 2022, whether it be Fed action, how certain businesses performed or, sectors behaved?

Portfolio Manager:

Yeah, the major development in 2022 was really the emergence of a cost of capital. You saw the U.S. Central Bank move rates from something close to zero to something close to 4% over the course of six to nine months. And what that will tease out over the medium term is businesses that are set to be resilient through those type of business conditions. Those tend to be companies that have a high degree of profitability. They tend to be companies that through thick and thin, tend to deliver robust free cash flow, and specifically, they tend to be businesses with low leverage that aren’t reliant on the capital markets to run themselves to feed their operating strategy. And so our focus from the get-go and throughout the management of these strategies has been to get in front of those companies when they’re attractively priced so that we can weather any different type of market environment regardless of circumstance.

Colin Dunn:

So what you saw in 2022 was an environment where the cost of capital went up a lot as Andy suggested, which makes the operating environment for businesses as well as for investors significantly harder than it was in the preceding years. We would’ve expected a variety of things to happen when that eventuality passed. Specifically high growth stocks that are very expensive should have underperformed more value-oriented stocks. Active equity investors should have outperformed passive equity investors. That happened, it was the largest share of active managers beating their passive indices since 2005 at over 60%. Highly profitable companies outperformed those that were less profitable or unprofitable. I should remind you that 42% of the Russell 2000 index still does not earn net income. And finally, highly-leveraged companies underperformed, those that have a more conservative balance sheet.

Kyle Helton:

As we sit here during the second week of January of ’23, there’s still quite a bit of uncertainty in the marketplace. What could be in store for smaller cap equities in the coming year?

Colin Dunn:

As one thinks about small cap equities heading into 2023, it’s worth noting that they just completed their sixth straight year of underperformance versus large cap equities, which is pretty significant versus history. Underperformance cycles are usually more in the order of four years. And married to that data point are a few observations on the value of small cap equities versus large cap.

First, the total market cap of small cap equities is only 4% of total equity market cap, which is low versus history. The average over time is more like six to 7%. And the strategist at Jefferies, somebody who we follow relative to small and mid equities, has a valuation model which currently points out that small cap equities are in the 14th percentile of valuation versus large caps over time, which is also quite low. So it strikes us that now as an interesting time to be allocating capital towards small cap equities and potentially away from large cap who have had a significant run of outperformance versus small.

I think I would add liquidity to the list of variables that folks have undervalued over the last 12 years amidst a pretty sanguine market environment. Obviously there’s been bouts of stress, but the bouts of stress have been pretty short-lived. The Fed has been there to save people. And to the extent, we have a higher cost of capital. It’s a more prolonged adjustment period in terms of valuation refinancing and a Fed that has not your friend. Something like liquidity could be of more value to asset allocators than it has been in the last 10 to 12 years.

Kyle Helton:

You’ve mentioned liquidity. We’ve now seen two pretty prominent private REIT strategies forced to pause redemptions these past few months. Can you kind of explain the importance of liquidity to a functioning marketplace?

Portfolio Manager:

I think one of the things that will be interesting to watch is back to some of these themes that Colin and I consistently observe in terms of the capital markets generally, which is an obsession to be clever, an obsession to kind of overreact in either direction to news flow. And really what we want to do is keep it simple and take advantage of the fact that there are very few people looking for the obvious in terms of wanting to consistently get exposed to companies that trade inexpensively but deliver outsize profit and cash flow. And so in the case of some of these funds where you’re seeing gates go up in terms of redemption requests, one of the things that we again look at from a simplicity perspective is the ability to maintain very similar exposure in a public market context at substantially lower fee on top of the ability to access liquidity on a daily basis against some of these alternatives that are positioned in the alternative class that may be ultimately outsmarting themselves in terms of what they’re ultimately delivering.

Kyle Helton:

In a marketplace full of kind of esoteric, opaque investment options for people, I think it’s interesting that the way you guys have framed this up, you make it seem so incredibly simple what it is that you’re trying to accomplish and that you’re doing. Is it really that simple?

Colin Dunn:

Well, I think our answer to that would be generally yes, the process of what we’re trying to execute is fairly simple. We do believe differentiation ultimately comes down to behavioral characteristics. Wise investors before me have noted there’s three ways to deliver alpha, that there’s an informational advantage which can either be illegal or easily competed away. There’s analytical advantage, which is certainly the byproduct of a lot of hard work. I think people in this industry are definitely willing to work hard. So again, something that can be competed away.

But the final and maybe most durable characteristic over time is a behavioral advantage. You are willing to do things that other people are not willing to do, whether that be patience, whether that be discipline, whether that be, “Go look at the company that nobody else is interested in.” So you do not have an interesting stock to talk about at a cocktail party, but that to us is the best way to deliver sustainable alpha versus the competitive peer group. That is why the third pillar of our investment process after quality and price is discipline. We believe that you have to be willing to be disciplined and wait for quality and price to align.

Portfolio Manager:

Really there’s been 10 to 20 years of inexpensive financing. And so that’s bred all kinds of derivative behaviors, which include market-wide obsession with alternatives, market-wide obsession with private, market-wide obsession really with trying to be clever to deliver outsize financial return. Ultimately, what we’re trying to do is keep it rather simple, get in front of highly profitable companies that generate a lot of cash flow that are ultimately self-funding which makes the sustainability of their business inarguable regardless of market circumstance.

We actually we’re looking at some research from Sanford Bernstein toward the latter part of the calendar year and they were trying to dissect what’s driven outsize equity returns, what they called ten baggers. One of the most ironic conclusions through pages and pages in chapters of research was that the majority of those companies were purchased at three times sales and 13 times earnings. Very much in the value strike zone. So to deliver outsize return with better downside capture, you really do not have to stretch if you know both where to look and you know when to act, which is ultimately where the discipline part of our process is so relevant.

Kyle Helton:

Turning the conversation to your portfolios, both the Cambiar SMID and Small Cap Value strategies, in terms of portfolio positioning, are there any unique themes or compelling stories about the type of names that have entered the portfolio of late?

Portfolio Manager:

I don’t necessarily think there’s anything thematic from a sector perspective. Clearly with the exaggerated selloffs that you’ve seen at different points in different sectors, notably technology over the course of 2022, that’s an area where we’ve been spending a good deal of time trying to mine interesting opportunities. But broadly, we continue to do what it is that we focused on for many, many years, which is go where there’s opportunity. And in the case of both SMID and Small Cap, opportunity has emerged across sectors through the course of 2022. Specifically in the fourth quarter we did add a technology name but we also added a name in healthcare. We’ve been active in the industrial sector through a good chunk of the year and also added some exposure as well in the consumer discretionary part of the landscape. Really it’s been fairly diversified, which is fairly consistent with what we’d see in any other given year.

Colin Dunn:

I suppose that’s really the theme that is most pertinent to us. As we tend to go where there’s opportunity, that is fairly obvious to us. And to some degree, less obvious to others. I think when there’s a powerful theme like renewables, like infrastructure investment, those tend to get played out among the consensus relatively quickly. And that means there’s a high price for participation, which is something we tend to be unattracted to. So sometimes you’ll find that the names that we’re interested in, you’re sitting in an empty conference room at a conference, while the really thematic interesting to the majority is a very packed conference room. So that’s a theme that is certainly prevalent for us in 2023 and has been for each year over the past 10, 12, 15 years.

Portfolio Manager:

The idea is not to be contrarian. The idea is to just observe opportunities that have kind of been left behind, kind of either under a rock or under some kind of cloud that has the broader market disinterested and do our own assessment in terms of what the forward opportunity really looks like in a risk adjusted context. And so we tend to find opportunities when people are looking elsewhere and that was certainly the case through the balance of 2022.

Kyle Helton:

Ben Franklin once said that the bitterness of poor quality remains long after the sweetness of low prices is forgotten. What are one or two companies that embody the Cambiar Quality | Price | Discipline process?

Colin Dunn:

A recent kind of prototypical example for us is Lamb Weston, we own it in a SMID. This is frankly a maker of french fries. There are some products that go into grocery stores, but a lot is going into QSR and restaurants. Historically, this company harbors a lot of the business characteristics and financial characteristics that we hold dear. They have 40% market share in a slow growth but consolidated industry. They have converted that market share into steady growth, high margins and consistent and strong returns on invested capital, consistent and strong free cash flow and an unlevered balance sheet. These are all things that we love.

Typically, a company like that is not attainable to us because it tends to carry a pretty high valuation. During the pandemic when restaurants were closed, people worried that another french fry would never be sold again and Lamb Weston was going to be impaired. We took the opportunity to participate in what has been a good value compounder over time at a low valuation. I think at the time of our purchase, various valuation metrics that we like, enterprise value to sales, free cashflow yield, were all very low versus history. We weren’t really sure exactly when we would get paid for that investment, but we were pretty sure over one to two years there was a high probability that we would do quite well.

Certainly there were fits and starts over the course of 2021 as it related to when restaurants reopened, there actually happened to be a bad potato crop, people got worried, margins were impaired. But because of the company’s strong market position, they were able to price for the bad potato crop, volumes did eventually reemerge. And here we sit today, the company having moved up a lot recently is finally it’s clear to the investing public that there has been no impairment in this business. Returns and margins are as strong as ever and we are now benefiting from evaluation much higher than when we initially started.

Another recent example for us is Health Equity. This is for our Small Cap strategy purchased to the end of 2021, so a little more than a year ago. Health Equity is the largest independent provider of health savings accounts. This is a growing area within managed care. The other big providers, UnitedHealthcare owns Optum. And then there is WEX, another company we own, is a manager of a bunch of small HSA plans that are marketed by other people. But Health Equity is 20% market share and is actually taking share from a bunch of smaller plans.

At the end of 2021, people were worried again that this business was impaired because a portion of their business had stopped growing and the HSAs had had two years of slow growth amidst kind of challenging employment, and people’s worry about having a health savings account versus a fully covered healthcare plan amidst the pandemic. And so the valuation got lower than it had been in a long period of time. This is a business I’ve admired for years, I’ve spoken to management. But the valuation was always way too high for us. There was a period of time where it was ten times sales on the 2017, 2018 period.

The other negative for the company was that they do earn interest revenue on the cash balances in these HSA plans. Recall in late 2021, people were worried we would never have higher interest rates. And so there was a worry that that particular part of their business would be impaired. So the valuation amidst these various worries about customer growth and interest earnings was lower than it had been in a long period of time. After digging into the company, speaking with management, I thought it was just a matter of time before HSA plans resumed growth because it does provide a lot of value to consumers and I was willing to take the- over that there was some chance interest rates would eventually be higher in the context of low valuation.

As it turns out in early 2022, they disclosed that their end of year sales of HSA plans were way higher than anybody expected. So the stock began to migrate back towards the middle of the valuation range. And then just a few short months later, it turns out the Federal Reserve has now gone on an aggressive rate high campaign, which has been very good for that stock. So we were able to participate in the secular growth story at a very low valuation because the investment community was worried about a few, in our view, transitory issues that as it turns out resolve themselves rather quickly.

Kyle Helton:

Finally, looking ahead to 2023, what is one message you’d want to convey to allocators and investors who are looking for guidance and signals to get back into small cap equity?

Portfolio Manager:

The other development over the last five to six years is actually publicly traded stocks have gone up for the first time in many, many years. You had a secular decline, I think, that started in the mid-’90s where publicly traded securities declined on the order of 35% and that’s turned the other way. Now admittedly, part of that is low quality stuff, the SPACs, the proliferation of IPOs that may never have warranted coming to the public markets in any way. But the reality is there’s still plenty of ways to get interesting exposure, not least relative to the large cap statistics that Colin pointed out where you’ve had six straight years of underperformance that has undoubtedly left people either completely ignoring the space or skeptical that there’s still long-term return when the reality is if you can again find the right stocks and choose the right time to act on those stocks back to the discipline concept, there’s as much opportunity as there’s ever been, which is reflected in the return profiles of both of these strategies.

Kyle Helton:

And as valuation dispersions widen and cost of capital goes up, that seems to be a pretty good backdrop for our team to operate and be successful on a go forward basis.

Portfolio Manager:

Absolutely, those are positive developments for active stock picking, particularly in a concentrated fashion, particularly where we would have the flexibility to be opportunistic. And part of that flexibility to be opportunistic is driven by the notion of discipline, having capital available when the opportunity presents itself which also dictates sourcing capital when stocks or markets get past a normal relationship between fundamentals and valuation, which is again what we’re trying to act on at a stock specific basis consistently.

Colin Dunn:

Andy mentioned before that we’re not contrarian and that is correct, but we are willing to go look in places that other people don’t find interesting. And as I look at where assets are allocated across the world today, I see a lot of allocation to growth versus value. I see a lot of allocation to large cap versus small cap. I see a lot of allocation of incremental flows to alternatives versus boring old equities. I see a lot of allocation to passive equities versus active.

I think it’s interesting that as there’s a potential regime change here, all four of those asset allocation decisions were on the wrong side in 2022. Maybe that’s a one-year phenomenon, maybe it’s an 18-month phenomenon, but there is a chance. Markets moves in cycles and so we just had a 10 to 12-year period where a certain way of investing worked. Low liquidity didn’t matter. Passive versus active. You were better just buying beta. Price did not matter. Profitability did not matter. But it is possible that on a go forward basis, all of those things didn’t matter in the last 10 or 12 years will matter in the next 10 or 12 years.

I find that it’s interesting that assets have been allocated and continue to be allocated in a way that may be quite opposite to the way things will work in the future. And so to the same idea that you expect your active equity managers to be looking at things that other people aren’t looking at, I think it also makes sense for asset allocators to be looking at asset allocation in a way that is different than all their peers.

Portfolio Manager:

And when you’re looking at small cap equities, one of the things to consider is the benchmarks that small cap managers are up against. The reality is those benchmarks are comprised of a disproportionate amount of unprofitable companies. So in the case of the Russell 2000 and 2500 value, which is what we benchmark our small and SMID cap products against, up to 45% of those businesses make no money. And so when you think about a higher cost of capital, when you think about overall tighter liquidity, those companies are likely to be relatively disadvantaged to those that can self-fund themselves. And so from an active management perspective, it seems quite relevant in terms of how one might select to both keep and further obtain smaller cap capitalization exposure overall.

Kyle Helton:

Well, this has all been very insightful. Gentlemen, our time has unfortunately come to an end. Thank you both for taking the time out of your busy schedule to chat with me.

Portfolio Manager:

Thanks, Kyle.

Colin Dunn:

Yeah, thanks for your time, Kyle.

Kyle Helton:

And thank you to all our listeners for tuning in. To learn more about Cambiar Small and SMID Value strategies, please visit cambiar.com. Thank you. And until next time, take care.

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