Discipline In Focus: Small & SMID Investing for 2025

   

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Cambiar SMID Value
Cambiar Small Cap Value

TRANSCRIPT

Kyle Helton:

Welcome to the latest episode of the QPD podcast. I’m your host, Kyle Helton, and today we are having an in-depth discussion on small and midcap investing heading into 2025. Over the course of 2024, investors took a greater risk on approach down cap where high beta characteristics have fueled strong index returns. This type of environment has created unique opportunities and challenges for managers like Cambiar who seek high-quality businesses. Joining us is Colin Dunn, Portfolio Manager for the Cambiar Small Cap and SMID Value strategies. Colin is here to reflect back on the hurdles of 2024 and shares thoughts on why 2025 could offer a broadening down. Colin, welcome back to the show.

Colin Dunn:

Hey, Kyle, good to be back here with you.

Kyle Helton:

To get things started, I think it would be helpful to our listeners if you could frame the investment environment over the past year and what it’s meant for small caps.

Colin Dunn:

Sure. I think a lot of people would look at the market environment broadly and think it’s been pretty constructive, not just over the last 12 months, but even extending to the 12 months before that coming out of the bottom in late 2022, the inflation worries really receded and so it has been broadly constructive, but you take a few steps back or I should say you zoom in a little bit and you’d notice that yes, the S&P is up a lot and particularly growth stocks are up a good bit, but there’s winners and losers over the last year and I think this phrase gets used in different market environments quite often, but it does feel a little bit like a two speed or kind of two lane economy or market if you will. So growth stocks are obviously doing pretty well. Mega cap companies, which are largely these big tech platforms in Nvidia are doing very well, so great earnings growth in the stocks are following and valuations are expanding, that’s great. And smaller cap stocks are lagging larger caps once again, so they’re up around 9% versus the S&P up closer to 20%, and so that’s a pretty big disparity at this point. Small caps are lagging large caps maybe the 10th year in a row, and I think rolling 10 year relative returns I read are kind of in the bottom one percentile over the last a hundred years, which is a pretty impressive statistic. But again, I think rather than lamenting that small caps can’t get any love, it’s worth pointing out that the earnings growth is fundamentally better with the bigger, stronger companies. And so that needs to flip for small caps to really get sustained love.

Kyle Helton:

It sounds like a very risk on environment. There seemed to be a preference for higher beta higher momentum stocks last year. Can you speak to that?

Colin Dunn:

Yes. We would characterize 2024 as more of a risk on environment. You’ve seen the S&P up 25%, the Russell 2000, up 10%, the VIX on a downward slope, high yield spreads compressing within the equity indices themselves. You’ve seen highly levered companies outperform companies with lower leverage and the second half of the year, in particular low ROE businesses, particularly companies that don’t earn any money are actually outperforming businesses with high ROEs. That’s all an environment where people are willing to take a lot of risk in the context of one or another. In this case, I think people are excited about the election being behind them and are a little bit incrementally excited about the policies of the incoming Trump administration versus those of the outgoing administration. I mentioned a bunch of traditional metrics we use to measure risk on environment, high yield spreads, markets being up, VIX being down. Those are all true, but there’s also a bunch of other areas one can look at to gauge risk tolerance. Certainly cryptocurrencies are back in mainstream media again, Bitcoin obviously up a lot and no value judgment on that one way or another, but there’s even kind of more silly things going on. Something like Fartcoin, which is funny to say in a podcast like this, but having a market cap kind of 700, 800, $900 million is just suggestive of a lot of risk-taking activity going on out there. I think retail participation is quite high. I think in the month of November after the election, retail volumes were as high as they were in the meme stock craze of 2021, and that didn’t age very well. Again, we’re not trying to throw cold water on a constructive environment, but it’s worth pointing out what is going on broadly in the market is suggestive of people taking a lot of risk and relative to our strategy, which tends to be more conservative than average bias towards great companies, good balance sheets, low prices, it’s going to be tough to keep up in an environment like that.

Kyle Helton:

Can you talk about momentum a bit? It was a driving factor in 2024. Obviously this can work for and against investors, though we’re not overly factor driven. I wonder if we could get a practitioner standpoint and how you’ve seen momentum impact portfolios last year.

Colin Dunn:

It’s been a momentum-y market that works two ways, good companies that have good business momentum, the stocks are following that business momentum and breaching new highs on valuation. While on the flip side, companies that are kind of struggling through cyclical downturn are finding new lows in terms of valuation, and that’s unusual to us and to put some names to that, we’ve experienced that on both the names that we have sold to early and others that we continue to own. And so we’ve owned some very good businesses like Booz Allen and Watsco in the HVAC sub-sector, Hubbell in the electrical components for the grid. These are three great businesses we owned. It’s at one point or another in 2023. Fundamental execution by those companies was terrific. The stocks went up and we sold them when valuation became quite demanding in terms of what people were expecting in the future in terms of revenue growth and margins. And while we were positively inclined towards the long-term prospects of those companies, we were concerned about valuation. The flip side of that is we own some good companies where certainly their business momentum is less strong than those three, but we are surprised by how low valuation has gotten almost suggesting that some sort of structural problem that we just can’t validate. And so we continue to own those businesses and are confident that eventually over the next 1, 2, 3, 4 years, we will do quite well on a relative basis. But it has required us to exercise the D in our discipline process to remain steadfast and kind of following our process.

Kyle Helton:

With the backdrop for 2024 set. Can you provide some context as to how the Cambiar Small and SMID Value strategies performed during the year?

Colin Dunn:

At Cambiar, We invest with a QPD philosophy, so quality companies are the top of the funnel for us and we look to engage or buy quality companies when the price offers us a skewed risk return. The final piece of our strategy is discipline. We want to have the discipline to wait for the convergence of both quality and price. That means that we don’t necessarily chase the things that are in favor or kind of chase a market or a risk environment that is improving for riskier assets. It means over time we continue to populate our portfolio with better businesses at better prices and spread our bets around set performance expectations for our down cap strategies. We’re generally looking to participate in up markets and protect client capital in down markets. That said, I think performance for our Small Cap strategy has been within our expectations for 2024 while our SMID strategy has perhaps been outside of our expectations in terms of its lag being more than we would’ve expected.

Kyle Helton:

What can you attribute to the relative underperformance of SMID?

Colin Dunn:

There’s a lot of reasons for that. These are idiosyncratic portfolios, high active share, and what we found when we looked at SMID is certainly profitability factor that we are very overweight to has been a headwind this year. Momentum has been a headwind. Beta has been a headwind, but at the stock level, I think back to this concept of two speed economy and our willingness to just go out and find good businesses and not really chase themes. That has hurt us more this year than in previous years. We continue to own most of the stocks that have been laggards for us because we’re very confident that in the next one or two years, these companies will hit their earnings growth inflection point and we’ll see the stock prices catch back up from very low levels of valuation. But it’s requiring a lot of discipline on our part in deep research to make sure we’re still on track with these companies being great businesses and that the inflection can happen in a timely fashion. Value traps are a real thing. We don’t want to have client capital invested in businesses that aren’t going to turn for three or four years. So a lot of our research is aimed at validating the structural strength of these companies, making sure nothing’s changed and making sure we’re close enough to an inflection point to provide a good relative return to client capital. All the while we think the portfolio still continues to hold the ability to protect client capital in a stressed market over the course of even a constructive year like 2024. The market goes through various periods of stress and what we see in the portfolio is that it holds up relatively well providing that second element of positive attributes for clients. The first one obviously being good total returns over rolling three and five year periods. And the second one is to protect client capital in times of stress.

Kyle Helton:

You’ve mentioned discipline is a key pillar in our investment process. I imagine last year it was a type of market that required a lot more of this. How are you approaching your research and evaluation process to ensure the portfolios are well positioned for success in the upcoming year?

Colin Dunn:

In periods like this, I think there’s a couple of things that we do to make sure we’re still on track. The first is just continue to do good deep research. We’re doing that. We’re validating that we own great companies, we’re validating there’s been no structural change. We’re checking to make sure we’re still close enough to an inflection point. We’re checking all those boxes, which suggests us it is just a matter of time. And having been through tough periods before, this is among the toughest. We know that key to coming out the other side is that third part of our philosophy, the discipline. You have to be able to tolerate periods of discomfort to ultimately recoup that performance when the tide turns in your favor. And it’s been hard to stick with some businesses that continue to lag in what many consider to be a pretty constructive market, but we’ve done that. So that being said, we feel pretty good about our opportunity to perform pretty well in 2025 and into 2026 with the strong companies we own at good valuations, close to an inflection point in their fundamentals.

Kyle Helton:

Can you talk about a specific business that would be an example of our discipline?

Colin Dunn:

We own this business called EPAM, which is a large IT services company that has a great heritage of growing strongly in the context of digital transformation at corporates via great technology knowhow in low cost service delivery. The company has suffered over the last couple of years for two reasons that are kind of distinct from each other. First of all, after an overconsumption of technology investment by large corporates in 2021 and early 2022, there’s been a bit of a recession in spending on things like software implementation and such, and EPAM has been hurt by that. Business volumes have been negative. The other piece of more idiosyncratic headwind for their business is the fact that they delivered a lot of service from Ukraine and after Russia invaded Ukraine, it required a movement of resources out of that geography to other places which caused some corporates to resist allocating more business to them.

So that’s the story there. And that has resulted in a stock that’s kind of down 18% year to date versus the benchmark up 9%. That’s a pretty meaningful lag on a business that accounts for two and a half percent of our portfolio at the beginning of the measurement period. That said, this is a company that has a net cash balance sheet, a history of high teens to 20% returns on invested capital, great margins and ability to grow strongly in the context of a secular trend of digital transformation on the part of corporates. They are going through both a cyclical downturn as well as kind of a reorientation of their business, but all research signs point to the fact this company maintains a strong competitive advantage and corporates will continue to invest in digital transformation because they have to. And so it’s just a matter of time. It’s not really a structural impairment of the business. In fact, just recently we’re starting to see signs that the business is starting to turn. Large software companies like ServiceNow, Salesforce.com are reporting improving bookings and improving numbers as they have reoriented their software stacks to incorporate AI and EAM is definitely going to be a beneficiary of that, and so feel really good about the medium to long-term risk reward. And so at the moment you have a business that’s turning a long track record of success in strong financial performance and evaluation that’s lower than it’s almost ever been as a public company. So we like that. It’s been a huge drag in our portfolio over the last 12 months, but we’ve had the discipline in the context of good research by Joe Chin to stick with it, and we think we’re on the precipice of a turn, but we feel pretty good about where we are.

Kyle Helton:

Looking ahead, what is your outlook for 2025? What type of environment could bode well for small caps and Cambiar?

Colin Dunn:

We generally feel pretty solid about the prospects for 2025. I think the most important aspect of that is the fact that we expect earnings growth to broaden out. We’re starting 2025 with an expectation for earnings growth of around 13 to 15% for the Russell 2000, really implying a broadening out of earnings growth beyond the names that you always see in the headlines. That would be a really good thing, not only for our individual companies, but for small and SMID cap stocks relative to the large caps in the context of more constructive outlook for 25. We feel pretty good about the way the portfolio is positioned today. Of course, we’ve mentioned before, particularly with smid, that we have lagged the upward move in the indices over the course of this year, but we’ve had the discipline, we think, to stick with our businesses because we feel like it’s just a matter of time before they turn. And to the extent things broaden out in 2025, we think will be beneficiaries of that discipline. And if the market does find itself more stressed out in 25 than it was in 2024, the portfolio continues to be stocked with highly profitable companies with clean balance sheets and conservative valuations, all of which has tended to provide us good protection of capital in past downturns if one of those should emerge for one reason or another.

Kyle Helton:

Thanks, Colin, any last thoughts before we let you go?

Colin Dunn:

I referenced before this has certainly been a hard year for us on a relative basis, and that’s always tough to stomach, but one of the things that keeps me relatively confident when looking forward is the fact that we have been here before and not even that long ago. So in the middle of 2021 in the height of the meme stock craze and you had SPACs IPOing left and right, our relative performance versus the indices was also quite challenged, similar to this year. And what did we do during that period? We were very frustrated then too. But again, do the research, check your companies and exercise discipline. And we did that and we were paid back actually quite quickly in terms of 2022 relative performance in a down market. But 2022 relative performance was quite strong. And the right thing to do in 2021 was not to chase what was working, but to focus on your research, focus on valuation, and know that it’s just a matter of time before you’re paid on a relative basis. And that was validated just 12 months later. And of course, there’s no promises for 2025, but we feel pretty good about the fact that we’ve checked our assumptions for this year and we remain convicted that we know what we’re doing and the opportunity for go forward relative performance remains quite good.

Kyle Helton:

And with that, we conclude this episode of the QPD podcast. A big thank you to Colin Dunn for sharing his insights on the challenges of 2024 and why he’s optimistic about the future of small cap value investing in 2025. We hope you’ve enjoyed valuable perspectives our guests have provided. If you found this series insightful, please subscribe, rate and leave a review. Your feedback helps us to continue to deliver content that matters. Thank you for listening and we look forward to bringing you more insights in the future. Stay tuned.

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