The Current Small and Midcap Landscape

 KEY TAKEAWAYS:

• The large cap vs small cap performance debate is more nuanced than the media leads on – small cap earnings are quite similar to their large cap counterparts
• Focusing on quality stocks and patiently waiting for these opportunities are critical attributes to outperforming
• Down cap investing is a fraught environment, making active management even more important.

 

   

 

TRANSCRIPT

 

Portfolio Manager:

We very much see ourselves as a value manager. We also tend to think of ourselves as having a bit more expansive view of value itself. Traditionally, price to book has been the main determinant with which the world has chosen to classify value stocks against growth stocks, and we don’t believe those two are mutually exclusive. What that means is that over the last couple of decades, an awful lot of value has accrued to businesses with outstanding, basically intellectual-property type moats, and we want to be sure that we’re including those in our universe of potential investment ideas.

Kyle Helton:

Hello, and welcome to a new season of the QPD Podcast, where we navigate the ever-evolving world of investing with insight, precision, and a keen eye for quality. I’m your host, Kyle Helton, Western Regional Director at Cambiar. Today, we’re delving into the intriguing world of small and midcap investing and our current higher cost of capital environment. We’ll be unpacking some of the recent portfolio moves and discuss why down-cap equity should be an attractive area for investors this year. Gentlemen, welcome to the show.

Portfolio Manager:

Hey, Kyle, great to see you.

Colin Dunn:

Hey Kyle, good to be back.

Kyle Helton:

Before we delve into small and midcaps, can one of you provide our newer listeners with a high-level overview of your team?

Portfolio Manager:

Sure, Kyle. In terms of Cambiar overall, what we’re looking to do is provide price-sensitive attachment to a concentrated set of what we believe are outstanding businesses that offer our clients’ exposure to consistent cash flow, above-peer profit margins, and the ability for those companies to do that with low leverage over extended arcs of time with the goal to participate in up markets, but importantly, provide downside protection to our clients to allow those returns to compound over time.

Kyle Helton:

I wonder if you might expand a bit on our process.

Portfolio Manager:

We define our process as Quality, Price, Discipline, and believe it really comes down to the discipline in the process, which is knowing specifically what it is we’re looking for and being patient until we find it. And what you will observe down cap is that, believe it or not, markets tend to see meaningful drawdowns in any given year on the order of 20% on average, and that’s at the index level. If you think about the stocks comprising that index, the moves can in fact be much more volatile. So if you know what it is you’re looking for, which we believe we do, and have the patience to wait until you see it, we think that there really is opportunity to outperform over extended arcs of time.

Kyle Helton:

So you’ve talked a little bit about quality and discipline. Understanding that the funnel starts with quality businesses, how do you incorporate valuation into your bias decisions?

Colin Dunn:

We like to think about valuation through the lens of the comment that price is what you pay value is what you get. So when we look at a business and look at all the positive attributes it has, be it an incredible market share or really special know-how in either intellectual property or how it does something and converts that into really high margins or great free cash flow and the low leverage balance sheet in a view that this stuff can all persist into the future amidst to growing end market opportunity, those are great attributes, something we’d all like to have in the businesses we own.

But to a degree, investor needs to be willing to pay a little bit above average for a business that is far above average. And that’s the way we think about it. We want to look at the price we pay relative to what we get in return. So if we get great attributes, there needs to be a price that offers a skewed risk reward over time. So it provides us some margin of safety in case something goes wrong but provides us as well an opportunity for sentiment to improve and create upside in the stock such that we have good total returns across the portfolio over rolling three- and five-year periods.

Kyle Helton:

Are there any sectors or industries that you are more or less inclined to commit client capital?

Portfolio Manager:

Areas of the market that tend to be a little more challenging for us to find the consistent cash flow characteristics that we’re seeking tend to be areas of the market that are inherently cyclical. So pockets of the economy like the material space or the energy space where, because those businesses are largely price takers around the certain commodity in which they traffic, they tend to be victim to cycles around economic activity itself or cycles around the commodity itself, which may have nothing to do with the economy. So while we’re mindful of being completely naked certain sectors, we do tend to find ourselves more often coalescing around areas of the market that do offer more attractive through the cycle characteristics around returns, profitability, and cash flow.

Colin Dunn:

Among the many mandates we have as portfolio managers, there are two that stand out that we consistently think about when we’re building these portfolios. First and foremost, being attracted and pursuing high-quality businesses. But the second piece is having diversity and drivers of return across the portfolio. So lots of ways to win, and that leads us to have a discipline towards pursuing opportunities in every sector. Even those that might have a little more commoditization versus extreme differentiation you’ll find in other areas as it relates to differentiation and drivers of return as well.

Within the technology and industrial sectors in particular, there tends to be many different business models in there like government classification codes that are catch-alls, if you will. And so we are able to find in those two sectors in particular a lot of different types of businesses, not just semiconductor or smartphone businesses and technology and not just metal bangers in industrials, but businesses that serve a variety of end markets and therefore have different value drivers that can provide diversity to the portfolio.

Kyle Helton:

A lot of allocators that I talked to, there’s no question that over the last 18 or so months, their opinion of small and midcap equity has been prevailing macro trends such as recession risk, monetary policy. Can you comment on the underlying fundamentals within small and midcap equity today?

Portfolio Manager:

One of the things you’ve seen with markets over the last, call it, 18 to 24 months is a very narrow set of companies meaningfully outperforming in terms of their own profit growth and associated stock prices. So if you were to take the S&P 500, for example, there’s around a dozen companies that have really comprised a large degree of not just the profit growth of the index but the stock performance as well. The rest of those companies have largely performed relatively close to their smaller cap brethren, and all the consternation around the dichotomy between large cap and small cap performance is a little bit more nuanced than the financial media might suggest. So when we look down cap, we continue to find a fair amount of interesting opportunities that have in fact been able to outperform.

One of the attributes of the small cap indices themselves is the composition within those indices of companies that make no money at all or companies that don’t tend to have a very attractive forward growth profile, like the regional banks. Unprofitable companies comprise on the order of 30 to 40% of those passive index instruments if you add, say, the regional banks, that adds another thousand or 2,000 basis points. So really, half of the index isn’t terribly interesting. However, the other half of the index can in fact be very interesting, and when you boil it down to exposures to 35 to 40 companies, there is all kinds of opportunities typically.

Colin Dunn:

Just to underscore something that should be evident within what Andy just said, there’s been a lot of criticism of small caps over the last 15 to 18 months, in particular noting are they ever really going to be able to keep up with large caps, and I think that there’s a lot of nuance that needs to be addressed there. Specifically, small cap earnings performance, either in 2023 or forecast over 2024, actually looks like what most of large-cap earnings performance has looked like and will look like. Just want to underscore, there’s really 10 or 20 companies that are driving a lot of the large-cap earnings strength that you’re seeing. The other 480 to 490 actually look a lot like the 2000 companies at the bottom of the market in aggregate.

Kyle Helton:

How do you decide to move on from a name and reallocate capital?

Portfolio Manager:

Well, we do believe that concentration and high active share are important elements of outperforming over extended arcs of time, one of the downsides is, in fact, the idea of opportunity cost in the portfolio, where each position really needs to be contributing. And so we had a situation over the course of 2023 where we had capital in a company that we had identified as checking all the boxes from a quality perspective, from a valuation perspective, from a capital allocation perspective, but as we moved through the life of that investment, ultimately the thesis had not played out favorably, which we were able to benchmark against a couple of larger-cap peers. The company I reference is Burlington Stores, which operates in the off-price retail space. And while Burlington continues to struggle to a degree with managing its own inventory and gross margins coming out of the very abnormal COVID years, its larger cap brethren, TJ Maxx and Ross, are not struggling with the same issues.

And so as we looked at that business and the capital we had invested in that business, we opted to move that capital to another company where we had previously been invested, and it exited for valuation-specific reasons as it broached levels it had not yet really seen before. And that’s a company called Ulta Beauty, which possesses very attractive long-term return characteristics on its own financials and the ability to deliver those profits and cash flows with an ultimately very low leveraged capital structure. That business over the course of 2023 saw similar valuation compression as a lot of the consumer discretionary space. So in that opportunity cost context, move the capital from Burlington into a business that we believed was of similar forward valuation normalization potential but with better overall attributes for our clients.

Kyle Helton:

Oftentimes, value managers struggle with differentiating between a company that is experiencing transitory headwinds versus more structural challenges, the classic value trap. How do you attempt to make this distinction in your underwriting process?

Colin Dunn:

I think the Burlington situation also serves as an example of operating with discipline. When we bought that company, we identified several reasons. We thought it was a quality business, why it was a special company, and therefore deserves to be included in our portfolio. We also identified a few things that need to go right to create the financial performance and ultimately the return that we’re looking for. And we write these things down, and we agree, these are the reasons we’re holding the stock, and this is what we’re looking for. These are mileposts along the journey that we have with an investment.

Having discipline means being honest with yourself when you’re not actually passing those mileposts and making a decision around is this still the best use of capital. Value investors must always deal with the tension between is a problem transitory or is it terminal and so if you have objectives, you’re clearly looking for along the way. It helps you navigate that gray area between what is a transitory problem and what is a terminal problem.

In the case of Burlington, we weren’t really sure. They weren’t meeting our checkpoints. It doesn’t mean that it has a terminal issue. It just means that we lost comfort with the things that we needed to see to justify this as a quality holding within our portfolio.

Portfolio Manager:

And in simple terms, we moved the capital to what we viewed as a better risk-reward opportunity.

Kyle Helton:

Yeah. Just out of curiosity, when an analyst brings you a new idea, where do your eyes first go?

Portfolio Manager:

Yeah, for me, Kyle, it’s the balance sheet. I want to understand how well-capitalized this business is, its ability to weather any kind of downturn. And the second thing would be a track record of consistent free cash flow delivery extending well beyond just the last couple of years.

Colin Dunn:

Yeah, certainly balance sheet and free cash flow are critical, but I’m also looking for the company’s margin profile, its return on invested capital, and its ability to grow over time as evidence that this is in fact a quality company. Can it grow? If its product is so good, it should be able to grow. And if its product is so good, it should be earning an above-average margin and/or return on its invested capital.

Kyle Helton:

What would you say to an allocator who’s hesitant to deploy capital down cap?

Portfolio Manager:

I think we like to think of ourselves as having a fair amount of humility, such that our ability to predict market moves is not necessarily a core competency. What we would observe, however, are a few variables. Obviously, the fascination with alternatives in the marketplace, which would include areas like private equity include areas like private credit, to us seem to be getting awfully crowded. What we would contrast that with is the ability to get targeted, select exposure to a concentrated set of profitable, consistent cash flow companies that, in contrast to some of these alternatives, offer transparency, offer liquidity, and offer a far less expensive price tag associated with that choice.

Colin Dunn:

In investing in general and as value investors ourselves, if we see persistent underperformance in a particular area and ultimately low price, we tend to be drawn to that to figure out if there is an opportunity there. And in the case of smaller cap equities, you can now see seven or eight years of rolling five-year returns, significantly lagging large cap brethren. And that has resulted in valuation opportunity that has quite skewed with smaller cap equities on the order of 13 to 15 times earnings depending on which index you’re looking at versus 20+ for the larger cap companies. I previously discussed some of the earnings differences between the overall S&P 500, the S&P 480 to 490, looking more like the smaller cap companies. And to us, that suggests this is not a small cap problem, it’s kind of the rest of the economy problem.

Over the last two years, you’ve seen gradually weakening financial performance for most companies as the economy has come off the boil during COVID. And so, we are very much sympathetic to the asset allocator that has to consider when to allocate more capital down cap. But I think it’s helpful to think about things from a big-picture perspective in that you’ve had years of underperformance. You have a low price. You’ve had a couple years now of weakening financial performance. Everybody’s always waiting for a recession to happen to allocate to small cap. And in large parts of the economy, you’ve been going through a recession for more than 12 months. And the likelihood of seeing a positive inflection over the next 12 months is frankly much higher, particularly in the context of financial conditions loosening. So again, we are sympathetic to the decision of when to allocate, but we’d note that there are a lot of conditions in place that suggest now is a decent time to allocate.

We’d also point out that when the all-clear signal is out there, and there’s a flag that says now is the time similar to, as when you get an all-clear signal with the stock, it’ll be too late. So we saw in November, people get excited about small capital, and Russell 2000 was up 15 to 20% in a matter of weeks. And if you have to go through committees or boards to get your allocation made, you’ll have missed the move when you have the all-clear signal. And that’s something we see at the stock level, too. We try to move fast as investors to allocate when we see an opportunity, never really knowing for sure when the inflection point is going to happen.

All that said, in terms of now looking like a potentially interesting time to allocate money down cap, we’d recognize small caps as an asset class overall, is a fraught category. As it relates to the Russell 2000, we’ve talked about 35 to 40% of the companies do not make any money. You have 15 to 20% in regional banks. Of course, there are many good regional banks, but as a group overall, pretty undifferentiated relative to other opportunities. And so those comments speak to the idea that if and when you do allocate money down cap, you need to consider the vehicle through which you do it. And we think an active manager that has a focused portfolio only looking for 40 or 50 strong companies in an otherwise difficult universe has a unique opportunity to deliver superior returns with better risk characteristics over rolling three- and five-year periods.

Kyle Helton:

Well, thanks, gentlemen. As always, it’s been a pleasure catching up.

Portfolio Manager:

Thanks, Kyle. Great questions.

Colin Dunn:

Yeah, thanks, Kyle.

Kyle Helton:

To learn more about the Cambiar Small and SMID value strategies and their corresponding mutual funds, please visit cambiar.com. I’m your host, Kyle Helton. Thank you, and until next time. Take care.