Navigating Through Small Cap Equities in Today’s Volatile Environment

KEY TAKEAWAYS:

• Investor discipline has been lacking for a while. As the cost of capital rises, investors are reconsidering the importance of profitability of cash flow in the near and medium-term. 
• Allocating to high active share manager is important as it allows for greater avoidance of the ‘pile in/pile out’ effect.
• Opportunity is now for small cap.  They are trading at one of the lowest levels relative to overall market capitalization in over 100 years.
• Buying on the way down. It’s very difficult to time bottom, there’s always more volume at that point than there is going the other way.

TRANSCRIPT

Portfolio Manager:

Passive money does not care what price it is paying, and so we are very much the opposite in terms of very much caring about the price we’re paying, where that risk reward relationship is skewed in each individual stock that ultimately comprises the aggregate portfolio.

Host:

Hello and welcome to the QPD Podcast. On today’s show, we have Portfolio Managers of the Small and SMID Value portfolios at Cambiar, two of the more talked about strategies at the firm. As the US equity market continues to digest Fed actions, rising interest rates, supply chain issues, earnings reports, the small cap environment inevitably become more challenging place to navigate making Andy and Colin’s job more interesting to say the least. So I felt it was a great time to have them back on to discuss what they’re seeing, especially what’s going on down market cap. Gentlemen, welcome back to the show.

Portfolio Manager:

Thanks Jim.

Colin Dunn:

Thanks Jim. Good to talk to you.

Host:

In previous interviews and commentaries going back a while you’ve spoken at length about aggressive monetary policies, fiscal policies that helped lift all boats, but eventually you anticipated this could potentially end. Is this volatility we’ve seen so far this year, is this the type of correction that you anticipated?

Portfolio Manager:

I think we thought there would eventually be some form of reset in terms of how folks were incorporating a cost capital into their overall financial calculations, and it’s a different environment when that input is zero than it is when it’s something more meaningful. So as that dynamic has only really just started to work itself through the broader market, I think this is what we would’ve expected that as a cost of capital is applied to various frameworks, it does cause a reconsideration of profitability of cash flow and exactly what the cadence of those profits and cash flows may turn out to be where with the cost of capital, those that can be delivered near and medium-term, certainly have much more value than those that may come, if at all, in the long term.

So our view is that reset probably has a ways to go in terms of how allocators ultimately choose to recast assets, and we feel like our process and focus on companies that aren’t at any risk in terms of what those nearer term and medium-term profits and cash flows might look like and less at risk in terms of what that may mean for their ability to finance themselves, should leave our clients in a relatively advantaged position.

Colin Dunn:

As many people, much smarter than myself have said, the time to buy insurance is before you need it. So exercising discipline in times when others are not will hopefully pay dividends when the cost of capital inevitably goes higher as Andy is referring to, which we’ve seen unfold over the last year-plus. We could not have predicted what would cause specifically the cost of capital to go higher, we would just observe that discipline in the market was not very high and that it made a lot of sense for people to get more discerning over time.

We also couldn’t have predicted necessarily that oil prices would go to 100 and energy stocks would be up 45% year to date while the index is down 10% to 15%. You can never really know what the ultimate market circumstances are going to be other than to trust that the investment philosophy you have is one that tends to work over time because you’ve seen it work in other periods.

Portfolio Manager:

I guess I would also say we’re generally thrilled whenever the notion of profits, consistent cash flow,  and low leverage are something people want, and from what we chuckle at times that moves out of favor, but the reality is it does, and for those concepts to be real again, I think is something that we’re excited about.

Host:

One question that I had, I know we’re talking small caps primarily in this conversation, but when you think about this move downward year to date, there’s been a lot of pressure on the so-called FAANG stocks, these larger cap stocks. That’s really, I feel permeated the market when you see weakness in Netflix and Amazon and Facebook. I’m wondering what your thoughts are regarding that, and maybe in the context of small cap too, the impact that some of those larger weakness and some of those larger cap companies. Was it a valuation issue, ownership; we know that a lot of these companies are widely held. Just wanted to get your thoughts on that weakness and how it may potentially impact your thoughts to see some of these market leaders be weak like this.

Portfolio Manager:

I can give you a couple thoughts. For one thing there was a pretty meaningful change in terms of the digital advertising ecosystem or paradigm with some of the shifts Apple made around really in simple terms, the sharing of data. So even big companies can have challenges navigating that type of new environment, and so that’s a piece of what I think fundamentally has gone on with some of these bigger ad supported businesses. There’s a second consideration too, which is that as we’ve moved more towards information and intangible asset type economy, there have been great advantages to the notion of network effect, the ability to derive network effects with a little bit less capital than you may have historically needed to do so. The flip side of that is that at some level that also limits the barriers to entry, meaning that there are new players or new competitors that can also stake their claim with relatively less capital than they might have had to do so in the past.

So that’s where you’ve seen competitors emerge to some of these perceived monopolistic businesses. Maybe the most notable one would be TikTok’s emergence over the last several years and really a great many of these bigger names aren’t really going anywhere, it’s more just a recalculation of exactly how profitable and exactly how long they will be that profitable that’s kind of entered the equation in a risk reward type calculus. So yes, in some cases there may have been some overvaluation but in others they’re not exceptionally expensive stocks at least anymore and so there may actually be some opportunity in some of those names that emerges, but it’s really back to this concept of a general reset around forward expectations, and again, a higher cost of capital in terms of how one might be executing a valuation calculation.

Colin Dunn:

Yeah. In terms of bringing back this concept of financial gravity, it’s real on a number of fronts as it relates to the financials of a specific company, but as well the valuation. These are large companies, Apple’s a north of $2 trillion market cap business, Google north of a trillion, and to some degree there are market share positions and depth of business that is fairly well along in its maturation profile, if not exactly mature today. So to that extent, you have a kind of law of large numbers. It gets harder to grow at 25% on the top line when you are as large as some of these companies are, that’s not to say they can’t grow at an above-average rate anymore. It’s just, maybe there’s greater realization now that, to Andy’s points, it is not a field without competition, and these guys have been pretty successful thus far, and the valuations reflected that. So you maybe have some financial gravity being exerted on their growth rates and as well, the underlying valuations that are assigned to those level of financials.

Portfolio Manager:

One other thing to point out too, is that we are a high active share manager, and so it is our belief that in order to outperform an index, you can’t look like an index, and that really implies some willingness to look outside the consensus and relative to the concentration of return in a number of those names you referenced Jim, to us that’s really reflective of, to some degree, lazy consensus thinking that caused the type of situation where the pile in ultimately leads to a pile out, and so it doesn’t diminish the long term position of a number of those companies you reference, but it does suggest some pretty meaningful, fund flows that just need to normalize.

Colin Dunn:

In terms of normalization, also this concept of mean reversion. We mentioned that small caps are trading at a market cap composition versus a total, at a very low rate versus history over 100 years, kind of near the bottom. Similarly, the largest 100 companies are towards the upper end of their contribution to market cap of the S&P 500, and they also trade at a higher valuation versus the index itself, and they have historically. Again, just boating for this, the idea that they’re stretched versus historical relationships, not just for the specific companies, but for companies like them over the course of history. Maybe some of that can persist because of the network effects that are more endemic to these types of businesses that did not exist 20 years ago. Still, there’s just lots of room for renormalization in favor of small cap assets or other assets in general.

Host:

That’s a good segue to my next question. Even though we’ve seen a lot of downside volatility, the Fed really just started the process of raising rates. We’ve seen what the impact that’s had on equities. So our listeners would appreciate your insights as to where are we right now? Are valuations low enough? Are there compelling opportunities now with just this move we’ve seen so far this year?

Portfolio Manager:

Yeah. There’s a famous book written by Scott Peck called The Road Less Traveled, and one of the critical concepts in there is this notion of delayed gratification and in our broader world, but especially the financial markets, there’s this idea of wanting everything to happen, fast, move fast, everything to be over quickly, and I think Jim, you point out something that’s true, which is that we’ve just started to move the cost of capital higher. So we would expect this to take time to work its way through the various parts of the economy that have been boosted and supported by a low or zero cost of capital. So you’re starting to see that in pockets, I think retail and consumer discretionary, you’re seeing inventories begin to pile up and that’s evident in some of the reports of some of the bigger players in the space, but we would expect it to cascade through a number of industries and sectors.

So what we’re doing is watching for opportunities where these negative developments, to us, look appropriately discounted and stay away from areas where that hasn’t happened yet. So these are good developments for the Small and SMID strategies, and certainly made that much better by the fact that the indices against which we compete are chock-full of entities that make no money, in the case of the Russell 2500 and the Russell 2000 Value, upwards of 40% of the names in that index are unprofitable.

So it’s a time to be considered and measured in terms of how you’re choosing to get your small cap exposure, and now is probably a good time to be considering small cap exposure. If you look at some of the bigger statistics over long arcs, I believe small caps are now about 4% of the cap-weighted indices broadly, typically that’s been a little closer to 7% and so even if you were to split the difference that would imply some good relative return potential for smaller cap asset classes.

Host:

We’ve talked about the macro for much of this discussion so far. Let’s talk a little bit about a couple of the strategies that you both manage in the Cambiar Small and SMID Value both ranking really well amongst their peers so far year to date, and that’s in an environment, I think I can say that hasn’t been great for quality. We’ve seen energy, some lower quality areas of the economy do really, really well. So how do you attribute some of the outperformance users experience so far year to date in those two strategies?

Colin Dunn:

Our investment philosophy is to buy better businesses at better prices. We think better businesses, these are ones with structural product or market position advantage that is converted into better financials do tend to compound earnings growth better over time, at a higher or above average rate. That said it doesn’t turn into a good stock until you have a price that doesn’t fully reflect the goodness in that business. That leads to a fairly narrow kind of lane of stocks we’re looking to buy, and in times when risk tolerances are quite high, it’s more difficult for that level of, I guess, ultimately conservatism to really keep up. But when investors get more discerning like they are now, it tends to be in our estimation, these types of businesses that hold up better because they’re less marginal and their fortunes are more predictable than the average company.

So we do expect this type of strategy to deliver when executed properly, good, medium to long term positive returns, but as well do so with lower volatility. We’ve been fortunate ourselves to experience that. We’ve talked a lot about the bias we have towards the type of companies we have, but at the end of the day, we’re an active manager who has a high active share portfolio of 50 names in Small Cap and 40 in SMID, and as it turns out, three, four, five of our holdings went up a lot while the market was going down because they had idiosyncratic risks that were uncovered through bottom up research. We allocated capital at a time when other people were afraid, and that has turned out to be in some of those situations, a nice tail end for our portfolio that you might not get in either a more broad or certainly a passive portfolio.

Host:

I touched on the energy space and I want to talk about it a little bit more. It’s been a phenomenal performing area. There’s some macro factors at play here and notably the Ukraine/Russia conflict, obviously pushing that sector higher. We’ve been underweight this area, Cambiar has been for quite some time. What are your thoughts on the sector now after such a phenomenal year and what might happen going forward?

Colin Dunn:

Sure. Energy is a place that we’ve struggled with our discipline. We’ve mentioned, we looked for strong businesses and strong industries and energy has not necessarily met those conditions. It’s extremely fragmented on the small cap end of the spectrum. There’s lots of companies operating in a space where anybody can bring incremental capital to bear, to bring more supply to the market and mess up supply demand dynamics. Ultimately capital discipline has been absent in that sector for a long period of time. But what we have observed over the last couple years is certainly the way the companies were talking more than a year ago, changed. They were talking about capital discipline, which was just talk at the time, and then that talk turned into an evolution in the way they were compensated away from just production growth, towards actual free cash flow production, and ultimately returns to shareholders, and then more recently we’ve seen them respond in a disciplined fashion to much higher prices.

So the end of the year when they previewed their 2022 CapEx budgets in the context of higher prices than a year ago, we noticed that they did not increase CapEx at an aggressive rate or production plans at an aggressive rate, which we thought was a validating factor to the things they had been saying over the previous 12, 15, 18 months. Then further at the end of the first quarter, when oil prices were even higher, and gas prices as well in the context of the Russian/Ukraine war again, CapEx, budget and production outlooks did not budge further laying another brick in the wall of this thesis of capital discipline.

So it’s still ultimately a challenged industry from an industry structure perspective. There much better industries out there from a fragmentation versus oligopolistic competitive dynamics, but there is significant evidence from the large cap companies down to the small cap companies that they’re more geared to delivering economic profits in the form of free cash flow and distributing it to shareholders, which is a big improvement, and has now, in addition to being talked about, been validated by not responding to high prices in the way the industry has in the past. So potentially it’s a more investible space than it has been in recent years.

Portfolio Manager:

In terms of the space itself it’s important to communicate that we don’t sacrifice any of our stock-specific criteria just to maintain a presence in any particular sector or industry. So, as we evaluate stocks in the energy space or the industrial space or the healthcare space, each stock has to rest on its own merits in terms of the financial profile of itself. So that’s an additional complication when you’re evaluating an energy business, there’s multiple dynamics at play, but they include some of the things Colin alluded to the first being that they’re typically a price taker in terms of the product or service that they offer, which doesn’t tend to lead to much inherent pricing power, so to speak.

Another important dynamic is certainly from a value context, when you’re going to look at cash flow and a discounted cash flow, or some sort of intrinsic value type calculation, these all have terminal values of zero if they don’t continue to reinvest in their business. So while harvesting near term profits and allocating more of that to minority equity holders is certainly different than the behavior you’ve seen for most of the history of the industry. At some point, most of these companies are going to need to reinvest, and so their ability to maintain that discipline to us is still very much an open question. So as we’re evaluating exposure to the space, it’s important for us to understand exactly what the medium and long term strategy might look like for it in that particular business.

Now that said, we have identified at least to this point one business that we think does possess a lot of interesting fundamental characteristics on its own merit. This is a business that has historically run itself with capital discipline from the get go. It seems to be in the DNA of the company. Secondly, it maintains an exceptionally strong balance sheet, net cash at this point, and their cost position in terms of the underlying asset or commodity in the business is exceedingly low. In this case crude oil, where they can produce and market their product for less than $30, which is a rather large spread from where we sit today. So the extent valuation met that combination of financial dynamics, it seemed interesting exposure, and so we’ve begun to dip our toe in.

Host:

So we talked a little bit about this at the beginning, but I think what a lot of our listeners want to know, especially allocators, where are we with respect to potentially getting more involved in equities and small caps today? So when we look out to the second half of the year, we’re almost getting towards the end of the second quarter, what would be one message you’d want to convey to potential allocators and investors who are thinking about small caps at this stage?

Colin Dunn:

In terms of calling the direction of markets again, we would profess humility on near term direction of markets. Certainly there’s many ingredients out there that suggest there’s potential for ongoing near term volatility and maybe even lower lows, but we would point out a few things. One, it’s much easier, still not easy, but easier to look over medium term periods than short term periods, and we would just observe that consensus does feel fairly negative to us. A lot of people are expecting the market to continue to be under pressure, and usually it gets harder for the market to go down when everybody thinks it’s going to go down.

We’d also note small caps has severely underperformed, obviously large caps, but Russell 2000 is down near 30% from its high, the median or average stock is closer to 40% down from its high. Again, these are coming off, maybe near record valuations for small caps. So even though it’s down 30% still, they’re not objectively cheap versus history. Nevertheless, the medium term story still looks attractive per the comments that Andy noted earlier in terms of the small cap market percentage versus the total. We’d also note that midterm election years of which this is one, tend to be highly volatile periods with large intra-year drawdowns, which is the situation we find ourselves in this year.

But historical data supports the idea that 12 months posts that large intra-year drawdown returns tend to be quite positive. You do have one way or another of resolving some of the uncertainties, and one way or another next year, we will know with greater certainty, what supply chains look like, what inflation looks like. So there are some reasons to be optimistic as you look a little more beyond the next few months or quarters.

Portfolio Manager:

There’s any number of disadvantages to getting older, but there are some advantages too, which is the ability to contextualize some of what you’re seeing, and I think to a degree, we feel like there are echoes of previous cycles in the past in terms of some of the air coming out of companies or situations where there was too much ebullience not just in the valuation described to future profits, but the scale of those future profits themselves. So akin to the late ’90s or 2000s, that took a number of years to work its way through the broader capital markets, but it also did not imply a wider economic crash. So it’s possible that’s what this turns out to be really, an adjustment from areas that were overvalued back more towards normative ground, and similarly, those type of companies that have long sat on that more normative ground become more attractive just in terms of a refocus and reprioritization of people’s capital priorities.

One additional thought, and I think we’ve referenced this on podcast past is that Colin and I are both students of those who’ve come before us in a value investing context, and Seth Klarman is one of those individuals, who’s had a lot of success and it has generally offered quite practical impression advice that again is contextualized by his experience across cycles, and one of the things he emphasizes is the need to buy on the way down. It’s very difficult to time bottom, there’s always more volume at that point than there is going the other way, and so it’s something we’re mindful of. It’s not trying to get to price perfection on entry, but really be buying when that risk reward relationship gets skewed, again to the upside based on a view of fundamentals and ultimately valuation, which is the most critical part of being able to deliver excess return over the rolling three to five year periods that we target to do.

Host:

Gentlemen, this has been great. I appreciate you coming back on and providing us some context on what’s going on in markets and specifically small cap equities. To our listeners out there, thank you for your support and please visit cambiar.com to learn more about the strategies we mentioned in the show.

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