Unearthing Hidden Gems: Navigating the Small Cap Landscape
In his latest interview, Cambiar Portfolio Manager Colin Dunn provides an update on the small and midcap landscape, highlighting intriguing investment areas. Dunn emphasizes the importance of active management down cap, detailing how it helps uncover undervalued opportunities in this dynamic market segment.
It appears to me we are starting to see the beginning of the broadening out of performance. After a near uninterrupted stretch of winning for the momentum trade through May and June, it appears to be faltering and there is more day-to-day tension between the winners of that period and the losers. While I am sympathetic to the drivers of the momentum trade – the fundamentals of those winners was outstanding – it seemed only a matter of time before financial gravity began to assert itself upon the strong growth rates and hefty valuations. On the flip side of the positive momentum trade, many businesses slogging through a period of extended cyclical weakness post-COVID and bearing the weight of the Fed tightening cycle on demand fell to valuation levels we have either not seen ever or in many years. With many of the marginal buyers and sellers of stocks day-to-day running a matched book of longs and shorts determined mostly by earnings momentum with less concern for valuations, one can imagine how this condition would emerge.
The story of broadening out is compelling but we should consider why/how that would happen. Simply, I think it is the partial convergence of fundamentals – with the recent winners seeing a slowing (but still solid) rate of growth, while the laggards get into the latter innings of their downcycle and begin to see improving fundamentals. Business performance could improve just because it has been 12-24 months of weakness, or because lower rates will release some pent-up economic activity as many corporates promise.
On the lower rates catalyst, while possible, historically lower rates are driven by weakening economic activity which has tended to further delay “pent up” demand. But this cycle has been unique in many ways, so I will reserve judgement on that front.
Areas of Interest
In terms of signs of the downcycle getting long in the tooth, the transportation sector is a helpful barometer as a toll taker on the goods economy. After 6-8 quarters of negative volume growth across some of the trucking verticals, we are starting to see rates of volume growth nearing positive inflection and spot rates are turning higher in some of the most cyclical areas. That is a good sign. We have also seen funding for biotech companies improve over the last few quarters, which should help the various life science companies we own grow book-to-bill and revenue soon thereafter, after a multi-year downturn. The long suffering nurse staffing sector is finally showing signs of emerging from a post-COVID recession. Regional Banks are seeing the relentless pressure on spread income finally abate. We are seeing significantly depressed stocks respond to the evidence of inflection in their respective sectors with big up moves off low levels.
Importance of Active
As it relates to capital allocation down cap, we are, of course, vocal proponents of active management. The passive index has had 40% or more of constituents losing money for years, with many laden with debt. While the gap between large caps and small caps in terms of performance and valuation has closed a bit in recent weeks, we believe there remains plenty of opportunity for relative performance given the years-long trend favoring large caps. Timing the bottom for small caps will be tough – the moves happen fast as we see over and over again. Recognizing the still elevated risk of some further economic softening, we get asset allocators could still be reluctant to move down cap, but we think some of that risk can be mitigated by selecting a quality focused actively managed fund with an emphasis on down side protection, while participating in up markets. We specifically aim to protect client capital in weak markets in the Cambiar Small Cap and SMID value strategies and have achieved this historically. Recent strategy performance also suggests this characteristic remains in place.
