SMID & Small Cap Value – 2020 Review

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Hello and thank you for joining our 2020 year-end podcast to update our friends, clients and partners on the Cambiar Small Cap and SMID Value strategies – both full-year 2020 performance and further clarity on how we have applied our steady investment process to these unprecedented times.  We continue to wish everyone well first and foremost, with optimism that 2021 will bring wider health, safety, and resumption of normalcy to all.

Where to begin, what a year, with so much already said by so many.  As has been well chronicled by numerous outlets, markets enjoyed a massive rebound across the second, third and fourth quarters of 2020 after a COVID catalyzed capital markets crushing in the first quarter of the year, with the S&P 500 cresting and ultimately finishing the year at a new all-time high.  While many have tried to capture the uniqueness of the market gyrations, research shop Strategas Partners said it well in noting “There has never been a bear market associated with a recession that lasted only four weeks.  Then again, there has never been a period in which the awesome economic power of the federal government and the central bank have been brought to bear so quickly.”  Put simply, equity markets spent 4 weeks going peak to trough, before a 9 month bull market of epic proportion commenced, with 90% of S&P stocks in an uptrend at year-end.

For additional perspective, consider some of the following market statistics chronicling 2020 movement.  43% of 2020 trading days saw a +/- 1% move, twice the annual average, with nearly 1 out of 5 days seeing a +/- 2% move and 1 out of 10 a +/- 3% move.  There were -12%, -9.5% and -7.6% daily drawdowns with 9.4%, 9.3% and 7% daily gains.  There were 480 IPOs, including 248 SPACs in 2020.  By comparison, there were 406 IPOs in 2000.  IPOs raised $167B in 2020 versus $108B in 1999.  The median price/sales of tech IPOs in 2020 was ~24x, against a median of 6x for most of the decade of the 2010s.  There were 150 companies with a market cap in excess of $250m that saw their stock prices triple in 2020, which is more than 3 times as many as any year in the previous decade^I.

Down the market cap spectrum, the Russell 2000 saw both its worst and best quarters ever in 2020, with the Russell 2000 forward P/E finishing the year at an all-time high of 31.7x, against a 16.2x long-term average.  While multiple expansion is somewhat typical coming out of a recession, 70% of names in the Russell 2000 finished the year 10% above their 200 day moving average, also a record.  Small cap stocks were trailing large cap peers by 1500bps in March, before finishing the year 200bps ahead, no doubt in part to aggressive ETF flows, which closed the year greater than $8B on a rolling 65 day basis, well above the 95^th percentile of observations^II.

In short a remarkable year for the world in general, equity markets included.

Cambiar performed well in 2020, with all domestic products delivering annual performance well in excess of their Russell Value Benchmarks.  The Cambiar SMID Value portfolio outperformed the Russell 2500 Value Benchmark by over 700bps (gross of fees), returning 11.9%, and the Cambiar Small Cap Value portfolio outperformed the Russell 2000 Value Benchmark by over 600bps (gross of fees), returning 10.8%. The information technology sector was the largest positive contributor to both strategies’ performance. While a software company catering to the automotive industry was the largest single driver in both strategies, the majority of holdings exceeded the index performance. Both the small and SMID strategies typically have sizeable representation in the technology sector, due to the significant value creation from technology across the economy, diverse business models allowing diversification of return drivers, and financial profiles that are consistent with our bias toward profitability and cash flow. While many technology businesses are notoriously expensive currently, we continue to find opportunities despite being price-sensitive buyers. Holdings in the healthcare and real estate industries also helped both strategy’s performance. On the weaker side, the consumer discretionary sector was the largest drag for both the small and SMID portfolios. Our underweight to this sector was a partial driver of the weaker performance, though some reallocation away from the sector near market lows toward what we perceived to be better opportunities elsewhere also hurt the performance here. An underweight to materials businesses was also a drag for both portfolios, as we took advantage of the market dislocation early in the year to invest in businesses we perceive to have superior medium to long term characteristics.

Most relevant to the management of these portfolios, they each weathered the aforementioned all-time best and all-time worst quarters for smaller capitalization stocks in the manner in which we would have anticipated for our clients.  We have long advocated the value of low downside capture to preserve capital in periods of stress and to augment compounding returns.  As such the outperformance of the strategies in the rapidly deteriorating equity markets in February and March was encouraging. As always, we look to identify businesses that possess a durable structural advantage – be it a differentiated product and/or market position. This should be verifiable in above average financial metrics over time, such as margins, return on invested capital, and ultimately a pattern of consistent free cash flow.  We also tend to avoid leveraged companies, with elevated debt potentially impacting the going concern realities of an ill-positioned business in a period of stress or simply disproportionately harming equity valuation in surviving businesses as an enterprise value based valuation metric compresses…both of these problems starkly evident as financial markets began to digest COVID-19 in early 2020.

The upward-sloping market trend of the second and third quarters in many ways mirrored the plummeting first quarter, and the relative performance of the Cambiar Small Cap and SMID Value investment strategies similarly exceeded the benchmark value indices.   As the election dust settled and vaccine efficacy became clear in early November, the aggressive market chase that quickly and intensely commenced was more challenging to keep up with for the Cambiar SMID and Small Cap Value strategies – with their inherent bottom-up characteristics of high profitability, high internal returns and low leverage in almost exact contrast with indiscriminate market buying of factors like beta and small size – with definitionally accompanying low quality and high leverage characteristics.  Still, it was another successful calendar year of alpha for investors in both strategies, and importantly continuing the positive 3-5 year rolling investment results we target for clients.

The intent is very much to move forward with the same patience and discipline brought to both strategies in recent years, to take advantage of regular market bouts of volatility to attach to good business at good prices.   The focus remains on owning the best businesses capable of delivering strong returns to our clients over the medium to long term. We always pursue balance across drivers of return, and risk.  On that last point, what is risk at this point?

On the one hand the seeming abrogation of moral hazard in the capital markets from the unprecedented monetary and fiscal support in response to COVID is a concern, evident in the fast-rising year-end market moves in everything from stocks to corn to houses to digital currencies.  In combination with high valuation levels on many metrics, notably P/E, there is the chance that future returns have at best been pulled forward, and at worst portend significant future aggregate capital risk.  While other financial metrics like price/free cash flow are less overtly out of bounds, measures like S&P market capitalization to US GDP now show 150%, versus 127% in 1999/2000 On a global GDP basis slightly less aggressive at 39% versus a similar level in 1999/2000. (source: Bloomberg).   How, why and when this might unwind itself back toward historical norms and averages is an impossible call, but rising reference interest rates and inflation measures early in 2021 suggest perhaps the forward post-COVID capital market regime will be a little different than that seen over the 2010s, with different valuation consequences across different asset classes.  Or not.

Hyperactive fundraising through the public equity markets is often a sign of froth. We recognize this is a sign of potentially excessive risk taking and are treading carefully as we evaluate current and potential new holdings. Those risks noted, we consider there may be some medium to long term positives from this form of chaos, unique to our free market. Much has been made over the last ten years of the de-population of public equity markets. Strategic merger activity, take over by private equity and a desire of many new businesses to avoid public company pains all conspired to winnow public markets. Whether through IPOs or SPAC mergers, many new companies are finding their way into the public equity markets, partially countering the latter condition and contributing to a much needed repopulation. Unlike much of the IPO activity of recent years recycling private equity capital, many of the current vintage are purported to be on the forefront of driving exciting change in the economy. An ugly shakeout is a growing possibility, due to excessive valuation or the unfortunate tendency for some lower quality businesses to tag along on the exuberance. That said, one way or another, public equity market investors will likely be left with a more diverse and exciting universe of companies to study, analyze and hopefully gainfully invest in. As we progress from the current condition through to a more stable period, we are excited by the likely opportunities for a price sensitive, active allocator of capital such as ourselves.

We have never been skilled at calling or timing market moves, or their scale.  Rather, we spend our days researching companies and industries, establishing whether their inherent business characteristics, long track of financial results, and forward prospects warrant inclusion in our “library” of potential stock ideas for our clients.  When and if valuation dictates attachment opportunity, we relish the chance to position our clients in companies able to internally generate long-term returns themselves and ultimately their minority equity holders, more so our ability to shift capital quickly in daily trading between stocks.   With COVID-19 developments and associated government support likely to remain front and center topics over at least the first half of 2021, we would not be surprised by more market gyrations. As such, it should be a fertile time to be an active allocator of capital to the domestic small and SMID equity markets. Our deep bench of bottom-up research analysts remain diligently committed, both in the office and remote, to execute.  We are pleased by the relative performance of the Cambiar Small Cap and SMID Value portfolios through the volatility, but not complacent.  And excited by the stock-specific opportunities that have presented themselves in 2020 for the benefit of our clients over a longer arc.  While there are countervailing winds of valuation versus liquidity, now may be an opportune time to not just to reflect on the risks of passive exposure for a longer-term investor, but in particular gain active 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 equity markets as Cambiar has shown.

Please feel free to reach out with any questions, and take care and stay healthy. Thank you for continued confidence in Cambiar and we look forward to being in touch soon.

Colin M. Dunn, CFA

Colin Dunn is an Investment Principal at Cambiar Investors.  In addition to his research responsibilities, Colin also serves as Portfolio…