Small Caps, Big Opportunities

Small Caps, Big Opportunities

Anu Rajakumar: US small-cap equities are at a critical juncture. Not only has the valuation gap between small and large-cap stocks grown exponentially wide by historical measures but also numerous small-cap macro tailwinds appear to be gathering force. Small caps also span a vast range of characteristics and performance drivers that even seasoned investors may not fully appreciate. So how can experienced managers have the potential to exploit them in the new year?

My name is Anu Rajakumar, and I'm thrilled to welcome Greg Spiegel, portfolio manager on our small-cap team, to delve into the intriguing landscape of small and mid-cap investing and why he believes these areas can offer attractive opportunities in the current market environment. Greg, welcome to the show.

Gregory Spiegel: Thank you. Thanks for having me.

Anu: Now, I know it's been a busy few months for you and your colleagues managing small caps, so let's start with a bit of reflection. Greg, what's been driving the recent interest in the small and mid-cap investment space?

Gregory: Sure. If we take a step back, we have gone through an extended period of underperformance for small relative to large, which has led to a valuation discount approaching historic levels between 25% and 30% discount to large, depending on how you measure that. It's our view that the entirety of that underperformance has been driven by multiple compression as opposed to earnings growth because small-cap earnings have actually been quite good.

In our mind, it's really investor skepticism around the sustainability of that earnings and cash flow stream. If we have a period of underperformance which has led to a discounted valuation supported by some potential tailwinds that we think are emerging sets the asset class up, I think, quite well.

Anu: All right, terrific. Some of the trends that appear to be affecting small caps are reshoring and globalization. Could you expand on that a bit, given there's been a major realignment in the global supply chain that has probably affected the space quite significantly?

Gregory: Sure. COVID really highlighted the risk in having very distant supply chains for critical materials, whether it's part of the semiconductor manufacturing supply chain or pharmaceutical supply chain. What we've seen and observed from our companies is a reshoring or a friendshoring where supply chains are moving back closer to the US, whether it's the US, Mexico, or Canada. We've also started to see what we're calling the re-industrialization of the US where manufacturing itself is being brought back into the US primarily in the middle of the country.

What this does is this creates a tremendous amount of economic activity, and that economic activity tends to disproportionately benefit small companies because they generate over 80% of their revenue inside of the US. As we think about the backdrop for earnings and cash flow and returns over the next several years, this activity provides a very attractive secular tailwind, I think, again, for many years to come.

Anu: Totally. In addition to that, as you'll probably agree, we have an interesting and evolving macroeconomic landscape ahead in 2025 between former President Trump heading back into the White House, interest rate cuts, potential for regulatory and tax changes. Greg, what role do you see macro policies playing in the success of small and mid-caps?

Gregory: I think it's quite important, and it's our view that the new administration is pro-business, pro-growth, and pro-US. Rolling back the regulatory regime, allowing the permitting process across sectors to be more seamless and shorter in time, will give CEOs confidence to make the capital allocation decisions around where to build a facility, where to expand capacity, and with that confidence, again, comes a lot of economic activity. It really ushers in sort of animal spirits.

With that, a lot of business optimism, which tends to really be one of the main drivers of small-cap revenue and cash flow. We think that that coupled with the underperformance, the valuation discount, the reshoring re-industrialization of our country, and the release of these animal spirits, again, really creates an attractive setup for the asset class.

Anu: Sure. What about taxpayer status as well? Is that another component of that, too?

Gregory: Yes, well, small companies tend to be full cash taxpayers because they're all headquartered in the US, they can't move their headquarters to low-tax jurisdictions, they can't take advantage of the arbitrage by having a significant amount of foreign earnings, and so corporate tax reform, again, is quite powerful for small companies.

Anu: Absolutely. I do want to talk about the case for active management within small-caps. I want to note that the small-cap index has seen an increase in its exposure to lower-quality companies which has increased over time. We'd love for you to just affirm if that's true and maybe explain why that matters when considering the implementation of small-caps, whether that's through active management or passive.

Gregory: Sure. Yes, indeed, that is true. At our last check, 45% of the companies in the index lose money on a gap basis. There's just reported losses. Now, if we look back over the past 10 or 12 years, that number has structurally increased, and really what happens is as the discount rate was zero, that invited a tremendous amount of speculation into the markets. That speculation manifests itself inside of the Russell 2000 Index. The price of inclusion, if you will, is to be born to be small. You don't have to make money, you don't have to have a net worth. We're left with a significant overhang of zombie companies and companies that don't make any money.

In addition, when you have companies that don't make money, they have to borrow to fund their operations. The leverage at the index level is about four turns of debt-to-EBITDA and it's all floating rate. You have a combination of a lot of money losers, very high leverage, and extremely low returns, which makes the index extremely risky and very low quality relative to, let's say, an S&P 500, for example.

Anu: Yes, sure. Speaking of S&P 500, maybe also, let's talk about valuation for a second. We obviously have the mega-caps and their ultra-high valuation, but maybe speak about the valuation gap. You mentioned it's historic levels. Talk about that, how it presents opportunities, and whether that also presents any challenges for you as a portfolio manager.

Gregory: Yes, so it's sets up an attractive opportunity because, again, the earnings have been pretty good coming out of small companies, it's been the multiple that investors have been willing to pay. If we think about all the items we just noted, they're all very supportive of continuous earnings and cash flow growth.

The ability to pay less for more over time, I think, is what helps to create attractive returns. The concentration risk also in the index is top of mind for investors. To have the diversification outside of those five, six, or seven names, I think, is hugely important. The valuation argument sets up one of many inputs into the case for small.

Anu: Yes, sure. Greg, we've spoken a lot about the tailwinds for small-cap, but conversely, tell us about some of the biggest risks that you see for small-cap equities.

Gregory: Sure. I would say first is more of the same. Continued concentration into the mega-cap companies, continued domination by large mega-cap S&P 500 is a risk even though the ingredients are all in place for an attractive setup. The second risk is where we are in the business cycle, and if investors think that we are potentially heading into a slowdown/recession, small-caps tend to be deemed quite cyclical in nature. Those usually will lead us into a recession and will also lead us out of a recession. That's something to be aware of as well.

Anu: Terrific. Maybe, Greg, now wrapping all of this up together, from what you've said today, how should investors position themselves to take advantage of these dynamics within small-caps going forward?

Gregory: We strongly believe active management is the way to have exposure to the small-cap asset class. As we discussed, the index is quite risky. It's filled with a lot of companies that lose money, has a lot of leverage. Active managers tend to focus on businesses that generate a lot of cash flow, have good balance sheets, very high returns. I would suggest active and I would suggest staying very high in the quality spectrum, especially in light of where we think interest rates will stay as well as inflation.

Anu: Great. Thank you very much for sharing those thoughts, Greg. Before you go, I have to ask you a quick bonus question which has nothing to do with what we just spoke about. [laughs] My question for you is, what's on your personal bucket list, something that you would like to do or see or accomplish within your lifetime?

Gregory: I'd like to ski 100 days.

Anu: 100 consecutively

Gregory: 100 days in a ski season.

Anu: Where would you like to do that in the world?

Gregory: Wherever.

Anu: [laughs] Do you have a favorite mountain or place in the world you like to ski?

Gregory: We ski a lot in Colorado, but I'm open.

Anu: [laughs] Like this. If I need to go to Japan, I will go to Japan or the Alps, wherever it may be. Great. Greg, thank you so much for all of your thoughts today. We covered a lot of ground when it comes to small-caps. You spoke about the valuation gap between small-cap and mega-cap being at historic levels. We talked about the reindustrialization, the potential for economic activity to pick up in 2025, rolling back a regulatory regime, corporate tax reform, all being some of the factors that we think will be tailwinds for small caps.

I also appreciate your comments highlighting some of the risks to that view, namely that the mega caps may continue to be magnificent and continue to be on this incredible rally. Also, understanding where we are in the business cycle, as you said, for small caps, early business cycle and early cutting cycle typically is good for small caps, but obviously, there's risk in that view as well.

Ultimately, the key messages here that you shared, active management, high up on quality, strong cash flows, good balance sheets, all make for a good recipe for small-cap investing. Greg, for all of those thoughts and more, appreciate you coming on the show today. Thank you for being here.

Gregory: Thank you for having me.

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