3 Top Managers Talk Small Caps
Small-cap Medalist fund managers discuss the rise of strategic beta, the move to passive, small-cap moats, and opportunities today.
The conventional wisdom: Investing in small companies comes with extra risks but also greater rewards for active managers who can add value in a less efficient market. Yet assets are flowing to passive funds across the market-cap spectrum--while the strategic-beta industry is boiling down active management to simple sets of factors that can be packaged and sold at lower cost. Meanwhile, a weak dollar and global growth are benefiting large corporations more than smaller companies, and anticipated post-election policy changes that were expected to boost small caps haven't yet panned out.
For insight, we turned to three leading small-cap portfolio managers who run funds rated Morningstar Medalists by our research analysts: Andy Adams, lead manager of Mairs & Power Small Cap (MSCFX); Don San Jose, who runs JPMorgan Small Cap Equity (VSEIX); and JB Taylor of Wasatch Small Cap Growth (WAAEX) and Wasatch Core Growth (WGROX). All three have proven able to find long-term opportunities regardless of the market environment.
Adams, San Jose, and Taylor shared their thoughts on July 31. The discussion has been edited for length and clarity.
If a group of data scientists got together and tried to duplicate your process and make a strategic-beta or smart-beta fund to compete with your process, could they do it?
Andy Adams: I just got back from a conference where a number of the presenters talked about smart beta. I was pretty shocked by the factors being used for the smart-beta models at this point. A lot of the factors haven't changed since I went to business school 20 years ago; I have degrees in math and finance, and worked on a quantitative factor model back then.
Where the rubber hits the road is how to weight those factors and when to shift the weightings. The jury is still out on whether smart-beta products can move from factor to factor at the right time.
I'd love to be able to just run models and spreadsheets but, especially in the small-cap space, it's important to go out and visit the companies and understand what's going on behind the financial statements.
As a case in point, return on invested capital is a great measure to look at. However, without visiting a company to understand what they're spending for maintenance versus what they're spending for growth, it's difficult to draw much of a conclusion from that number.
Don San Jose: There are going to be times when things are changing in the real world that models aren't capturing in real time. One of the things that we look for is strong capital allocation. The numbers may tell one story, but you need to sit down with management and visit the plants and see what they're investing in and try to figure out whether it's organic growth or inorganic growth or maintenance. While you may see a certain quantitative factor come up in a model, it may not be telling the true story. That is why we make a point of visiting every company that we invest in and a lot more that we end up not investing in.
JB Taylor: I agree. I'd add that quant models and smart beta are inherently a little shorter-term in perspective. We can add the experience of a long track record and a stable investment team and also a very long-term perspective. We can look for growth companies that may not have a certain factor that is in vogue in the market but have some sort of long-term good competitive positioning that will allow them to thrive.
We also spend a ton of time researching the quality of a management team. There are aspects that can't be quantified or measured. When you find a phenomenal management team that deploys capital in an efficient manner over a long period of time with great success, that's pretty special--and something that's very hard for smart-beta models to capture.
San Jose: A lot of the quant models end up getting out of a factor at exactly the wrong time. Our longer-term perspective provides the opportunity to zig when the market zags. With these smaller-cap names, especially the lessliquid ones, if you have high conviction, that allows you to build up positions when factor investing may be going the other way.
Have you seen distortions created by the flow of money to passive strategies and strategic-beta strategies in the small-cap area?
Taylor: It's not something that we spend a lot of time discussing, because it's out of our control. But there are moves in the market that at times seem less rational, less based on fundamentals, and you have to attribute some of that to the massive inflows into passive vehicles. In that period immediately after the election, you had the Russell 2000 Value Index jump 20% in something like 30 or 40 days. The Russell 2000 Growth Index moved much less. The components of the value index that jumped the most were all these companies that had been basically left for dead--companies with inferior business models and lower returns on capital in lower quality industries. Adams: We noticed after the election a lot of money moving into small caps. A correction at some point will be a wakeup call for the market, but it's just not a macro factor that we focus on closely.
San Jose: Post-election is probably the most recent time frame when we saw exaggerated movement probably driven by flows to passive. Prior to that was 2013, when biotech was really ripping. That's not an area that we commonly participate in, but I remember thinking that this couldn't be all active generalists pouring into one sector.
Taylor: Flows into passive strategies can create headwinds or crosswinds in the short term. But over the long term, flows into smart-beta strategies and passive investment vehicles create opportunities for fundamentals-focused investors. When those factors turn, when people start selling it with the same momentum that they bought, then good companies will be considerably cheaper.
Is determining quality and competitive advantage within the small-cap area more challenging than in the large-cap space, given that it's at least perceived as being an area that's more susceptible to competition?
Taylor: I've never thought of it as being more difficult. We have literally thousands of companies to pick and choose from. You do find a lot of companies that don't meet the quality bar, in terms of business model strength or management quality, but we have more opportunities to sift through. As you get into bigger caps, companies are well understood. They're pretty high-quality companies to have reached that size. There is more differentiation in the small-cap space.
San Jose: Within small caps, it's actually probably easier to rule out the lower-quality ones. In our benchmark, the Russell 2000, there are hundreds of names that we know won't even come close to meeting the quality standard that we're looking for. Within the S&P 500, you might deem all of those companies as being investable at some point in the business cycle, whereas in our universe, there tends to be a cleaner line, especially among the smallest names.
Adams: As for competitive advantage, the companies certainly can have scale within the product categories where they compete. They don't dominate an entire sector or an entire industry, but if they dominate the particular market niches they're in, that can give them a strong competitive advantage even relative to a much larger company.
What is the state of valuations in your opportunity set? And how should investors set their expectations?
San Jose: The market's valuing these small-cap stocks at pretty high levels, especially compared to earnings growth that's moderating a bit. People have to be cognizant that a lot of these stocks are priced for perfection. Even if you're hitting your target, that actually may not be enough.
Adams: Relative to large-cap stocks, the valuations look reasonable. But what we're seeing in particular this quarter is that larger-cap stocks appear to be benefiting from an improving global economy. This disproportionately helps larger companies that have more international exposure.
Whereas for smaller-cap stocks, a lot of the policy changes that could have benefited them, like tax reform, infrastructure spending, and deregulation, haven't played out. We've lost some confidence that those things will happen, and it's made for a more difficult environment for the small-cap stocks. That said, it creates opportunities for us. Overall, I think 2017 is going to be difficult for the small-cap market, especially relative to larger caps, but longer term, we still like smaller-cap stocks.
Taylor: The thing to be worried about is how far we've come this fast. If you look at the period from, let's say, the end of 2011, the Russell small-cap indexes have compounded at about a 14% annual rate. But the average small-cap company in our investment universe has grown their revenues maybe 5% to 6% per year. You had returns well in excess of the revenue growth, and valuations are up. In addition, the operating margin increases that we had for several years have moderated, and actually started to go the other way.
It's not an easy period to find stocks, but on the flipside, you have a large universe to pick and choose from. You can always find companies that are doing something a little bit special or companies that are growing faster than the norm, but you do have to be very prudent in terms of what you pay and when you enter positions.
Where are you finding opportunities? Are there any themes or trends?
Taylor: Our portfolios are fairly concentrated, and we have a good mix of eclectic names; we don't really jump on themes, per se. But in technology, while valuations are up, there are names in the SaaS [software as a service] software space that are incredibly dynamic, taking large amounts of market share. They're growing at incredible rates--25%, 30%--while spinning off free cash flow with business models that have recurring, sticky revenues and loyal customers.
Adams: We also don't generally focus on one sector versus others. That said, we think there's an opportunity right now in the financial space. We have built up some positions in the banking industry, in particular asset-sensitive names. The vast majority of their revenue and profit is from the U.S., so if we do get any kind of tax reform, they'll likely benefit. With deregulation, we could see a better environment for the banks, on the M&A side. Then if we do see interest rates start to move higher, over time that should benefit the space as well.
A long-term differentiation of our portfolio versus peers or the benchmarks is that we've always had an overweight in the industrial space and probably always will. We're looking for longterm, durable competitive advantages, and typically these industrial companies fit well with our strategy. Another thing that differentiates us is that we focus on the upper Midwest, and we've got a lot of well-managed industrial companies here that typically keep their market share in down markets and tend to pick up some share in recoveries. San Jose: We are also more bottom-up, and not looking necessarily for themes. We've added everywhere from building products to technology this year to date, but the one area where we've added a little bit more than other sectors is financials, for the same reasons Andy mentioned: interest rates and less regulation and potential tax reform. We used the unwinding of the bank trade that you saw after the election to add some asset-sensitive names earlier this year.
Banking on Banks
Let's get into some individual names. Andy, you held on to United Bankshares UBSI after it recently bought out PrivateBancorp.
Adams: United Bankshares serves the Washington, D.C., market. Where we've gone outside the upper Midwest is when we see better opportunities elsewhere. Banks are very geographically focused, and the D.C. market is a good place to be positioned. We like the demographic growth of that marketplace and the local competitive environment. The key is having good access to the management teams. We're well-known in the upper Midwest, so we have no problem with access to companies based here. When we get outside that area, we want to make sure we can do all the due diligence that we need to do. With United Bankshares, that's been the case.
San Jose: Glacier Bancorp GBCI has been a long-term holding. We got involved right in the middle of the [financial] crisis. Like a lot of the banks we own, it is in an end market where there's less big bank competition. In Montana, Idaho, and Wyoming, they're able to have a very solid share and a very sticky deposit base. And we like the management team. They've created a lot of value, mostly through acquisitions that have very low integration risk. Their ability to use their stock, which is a pretty high-priced currency, to buy smaller banks has been a very successful strategy over time.
Taylor: We increased our weight in banks about two years ago. We had been fairly underweight in our small-cap growth portfolios since before the financial crisis. We thought the banks had opaque balance sheets, and that growth would be slow for much longer than expected. About two years ago, we started to see net income increase year over year in the sector, and it was real growth, not just taking money out of extra reserves. We identified small banks in geographies where they had a good market presence. Small and midsized business customers have not been well served by the consolidation of the larger banks, so a well-run bank with good commercial bankers has a good chance to take share and continue to grow. An example of that for us is Texas Capital Bancshares TCBI. They're growing nicely but are still a small percentage of the share in the Dallas market. They have much larger consolidated competitors to take share from and that should serve them well over a long period of time.
JB, one of the larger bank holdings in your portfolio is a U.K. bank, Metro Bank MTRO:GB. What's the thesis there?
Taylor: Metro Bank is somewhat of a phenomenon. In the mid-2000s, we owned Commerce Bank, based out of New Jersey. Vernon Hill, the current chairman of Metro Bank, was the CEO of Commerce. It was a low-cost deposit-gathering story that grew well from an IPO until they sold to Toronto-Dominion (TD). Over many years the stock price compounded at 20%-plus.
It's an incredible story. In his 60s, instead of cashing out and retiring, Hill decided to move to the U.K. and start over. He thought that a bank focused on giving retail and small-business customers great service would play well there. He started the bank in 2009, and it has been growing phenomenally, even eight years later. Last quarter, they grew their deposits 47% and their noninterest bank deposits 70%. They're simply taking massive amounts of share. They're also rated number one in the U.K. for mobile apps and online access for customers. That market has been dominated by five or six banks for 100- plus years, and they just aren't as nimble as Metro Bank. We think this is one that could be tucked away for a long period of time.
To shift sectors: WESCO International WCC was in the news with an earnings disappointment [in late July], and the shares took a significant hit. Is this a story of being unable to expand margins and of revenue growth at this point in the cycle? Or is it a story of Amazon.com (AMZN) taking share from distributors?
Taylor: WESCO is a very high-quality industrial distributor. Industrials is a place that we were more heavily invested in three years ago. As growth rates slowed our positions got smaller as well. But recently we started looking at higher-quality companies in the industrial space, recognizing that we had something of an industrials recession for the past two or more years. We thought the market didn't appreciate where WESCO's earnings could go, even if the economy was just decent--and if it got any kind of tailwind, how much better it could be.
In the past quarter, we saw good things on the revenue side, but the market was disappointed that management is going to invest more, which might hold back margins. We don't think it's a fundamental change to the story. But an additional overhang is that any distributor is assumed to be threatened by Amazon. In WESCO's case, we don't see that happening.
San Jose: We own Pool Corp (POOL), which is a distributor of pool equipment, mostly to contractors. They've put up some great performance over the years, and in an environment where Amazon does tend to dominate the headlines, they had a solid quarter, 7% organic growth. Their business model is predicated on being the dominant provider in local regions, as well as having national scale. Pool Corp's customers need customer service, quick turnaround times, and advice on what products work best in certain situations [which Amazon can't necessarily provide].
What dogged them in the second quarter was a slight margin disappointment. People thought that must mean pressure from Amazon, and investors were quick to sell the stock off--even though Amazon's actually a very small player in the pool-supplies business.
Adams: It seems like in almost every one of our investment meetings, Amazon gets mentioned. Amazon is certainly going to be disruptive in a lot of different areas. On the small-cap side, however, we don't have too much in Amazon's path. For example, Tile Shop (TTS) is a company that we've been adding to recently. Given simply the physical properties, the weight of the tiles, it would be difficult to displace them from an online standpoint. We believe there are many niche businesses that aren't in the crosshairs of Amazon.
What's keeping you awake at night?
San Jose: I feel good about the individual positions in the portfolio, but I do worry about absolute valuation levels. If there is some unforeseen circumstance that takes the market off track, what kind of damage could that do across the market and ultimately to our portfolio? That said, it would also give us the opportunity to add to the strongest conviction ideas, and potentially add new names. Our longer-term philosophy ends up being a competitive advantage over a long-term time frame.
Adams: We set upside and downside targets for all our stocks, and at the end of last year and early this year, it felt like we were getting pretty stretched from a valuation standpoint. Luckily, the volatility of this quarter has given us better opportunities here and there, so I'm feeling a little bit better on the valuation front.
We've had such low interest rates and pretty easy money for companies in general. A lot of them have taken advantage of that, rightfully so. We've tried to be cognizant of that, making sure that, if we do go into a downturn, none of our companies has become too leveraged. We're a long way into this bull market. Not that we see anything on the horizon that's really going to disrupt things, we are just preparing ourselves so that if there is a downturn, the portfolio will be well positioned.
Taylor: The thing that keeps us up at night is really the same thing that always keeps us up at night: making sure that we have the highest- quality companies in the small-cap universe, with the best management teams. The longer you get into an economic cycle, the more companies are able to put up decent numbers over a long period and show good financial success. Understanding which companies have the wherewithal, the decision-making ability, the balance sheets, and the business models to go into a much tougher economic environment and still take share and position themselves for growth on the other side--that's where we spend our time worrying. That's what keeps us up.
Dan Culloton does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.