SMID & Small Cap Value – 1Q20 Review

Transcript:

Hello and thank you for joining our latest podcast to update our friends, clients and partners on the Cambiar Small Cap and SMID value strategies – both first quarter performance and further clarity on how we have applied our steady investment process to these unprecedented times.  We wish everyone well first and foremost.

Financial markets endured a great deal of stress in the first 3 months of 2020, with the S&P seeing its 5^th worst performance quarter in its history, and the Russell 2000 having its worst quarter since inception in 1979, as small-cap stocks trailed their larger-cap brethren by a further 1000 basis points.  March saw wild volatility, with only 1 day of trading seeing a less than 1% move.  The VIX, a common volatility gauge, averaged 57 points, nearly 3 times its 20 year average of 19.6^I.  Obviously the unfolding COVID-19 pandemic was the primary source of market fear, as a health crisis of unknown magnitude spread around the world causing sickness, death and dramatic declines in economic activity for an unknown duration.   The further accelerant an emerging oil market share war, catalyzed by the demand destruction from COVID-19.

Amidst these market disruptions, the Cambiar Small Cap and SMID Value portfolios continued to be tightly managed by a highly engaged analyst and portfolio management team.  We took action to pursue sought after holdings at lower valuations, while exiting certain positions that we believe that are likely to see too great a fundamental deterioration or are just an unfortunate casualty in the on-going process of bettering the overall portfolio. The outputs in terms of our first quarter performance were strong in relative terms, with over 450bps of alpha, gross of fees, delivered in both the Cambiar Small Cap and SMID Value strategies, helping to preserve and build upon the wide return delta between the strategies and their respective benchmarks delivered over the last 1, 3 and 5 year time periods.

As previously articulated, protection of principal has been a core underpinning of the strategies, and the down capture statistics continue to reflect it.  Over the last 3 years the Cambiar Small Cap Value Strategy has outperformed in 4 of 4 down quarters, with an overall down capture of 83.8%.  The Cambiar SMID Value Strategy has outperformed in 3 of 3 down quarters, with an overall down capture of 76.1%, over the same three-year period^II.  Our belief has and continues to be that stronger companies produce more durable and growing earnings streams over time that better weather leaner times given robust free cash flow and modest leverage allowing for a tangible financial cushion versus peers that markets reward.  Perhaps not in any single day of trading, but certainly over longer periods of measurement.

We have written and spoken at great length in recent years on a number of problems that we believe are now front and center in global and national financial, economic and political discourse.  Chief among those issues poor market structure, passification and ETF’ication of investing tools, and debt-laden corporate balance sheets.  With these structural problems appearing to evidence their weaknesses in grand scale in recent weeks, we continue to think the worth of an active manager focused on value-creating businesses with conservative balance sheets is only just beginning to prove itself out. To be clear, delivering strong investment results is about picking the right stocks, which starts with robust industry and company-specific research at the analyst level.  Cambiar has and continues to invest heavily in our domestic analyst team, and stock selection has been the largest source of the outperformance produced by the portfolios in recent years, including 2019 and the most recent quarter.  In combination with a clearly defined ‘Alpha Hypothesis’ for both individual stocks and overall portfolio construction, we continue to execute with a view to deliver attractive returns to clients over the medium to long term.

Initial underwriting of any position remains the most critical determinant of both forward return potential and risk mitigation.  As always we look to identify businesses that we believe possess a durable structural advantage – be it a differentiated product and/or market position that is verifiable in above-average financial metrics over time – in margins, return on invested capital, and ultimately a pattern of consistent free cash flow.  Metrics we are particularly sensitive to are of course absolute valuation in and of itself.  And then leverage – which can not only impact the going concern realities of an ill-positioned business in a period of stress, but can also disproportionately impact equity valuation in surviving businesses as an enterprise value based valuation metric compresses.  Both of these problems were starkly evident as financial markets began to digest COVID-19.

With our stated preference for quality businesses, the Cambiar Small Cap and SMID Value portfolios skew toward highly profitable companies, with low leverage and tend to have a slightly above average market cap versus their benchmarks, given larger companies tend to post superior margins, returns and free cash flow characteristics.  “Risk on” rallies, where lower quality businesses rip to the upside may present a temporary headwind to performance on a relative basis.  But we are prepared to endure these likely periodic events as we believe the types of companies we are pursuing are more likely to be able to compound annual returns over a multi-year period given their superior market positions reflected in their margin and return profiles. As previously mentioned, we also believe this bias is more likely to yield better downside capture as market selloffs continue to occur.

In the small-cap value strategy, we added new holdings in the defense, industrial equipment auction, government consulting, electronic payments, and triple net REIT sectors. While we entered this period with some portfolio cash, we funded some of the purchases with the sale of holdings in the energy E&P, refinery, and bank sectors.  The SMID value strategy, also saw some activity, with new holdings in the transportation, professional staffing, leisure, medical tools, data center REIT, and software/services sectors. Though the SMID portfolio also entered this period with portfolio cash, we still funded some of the purchases with the sale of holdings in the energy E&P, software, petro-chemical, bank and airline sectors.

While we have been more active over the last few weeks than usual, the vast majority of the portfolio holdings remain in place, as the underlying companies were actively selected for their durable business characteristics, attractive prospects for future value creation, robust financial characteristics and the unique drivers of return they bring to the portfolio.

The trading environment remains very fluid, with large day-to-day moves at both the stock and index levels early in the second quarter.  Though volatility and credit spreads have begun to move down meaningfully, this remains a violent, uncertain and taxing period in the capital markets, no doubt exacerbated by a sense of personal health risk we all are facing as we retreat to our homes. These issues could all very well still get worse before they get better. Nevertheless, we remain comfortably focused executing our stated strategy on behalf of clients.  We are encouraged by the relative performance of the Cambiar Small Cap and SMID Value portfolios through the volatility, and excited by the stock-specific opportunities that have presented themselves for the benefit of our clients over a longer arc.  Further, smaller-cap stocks are exiting one of the worst five year periods in their history and have led the market out of 9 of the last 10 recessions^I.  That noted, now may be an opportune time to not just consider exposure for a longer-term investor, but in particular gain exposure through a manager as focused on the specific characteristics of each individual holding and the aggregated ability to weather the inevitable downside periods in small and midcap markets as Cambiar has shown.

Please feel free to reach out with any questions, and please take care and stay healthy. We look forward to being in touch soon.

Cambiar SMID and Small Cap Value portfolio managers provide an update on their portfolios during the current bear market.

Cambiar SMID and Small Cap Value portfolio managers provide an update on their portfolios during the current bear market.