What are the attractions for a European investor of treating investment in US smaller capitalised stocks as a separate and distinct asset class? The John Lewis Partnership pension fund, for example, has recently awarded a dedicated US small/mid-cap mandate for 20% of their total US portfolio. As their other US managers are not constrained by size, this could lead to around 35% of their total US equity portfolio being in small and mid cap stocks, over double the market weighting. Yet the US equity market is generally perceived to be over-valued relative to other asset classes, and within that, the small cap sector is now regarded as being fairly valued relative to large cap.
For Andrew Chapman from John Lewis, the draw of the US small cap market is quite simple - “it is an area where managers can add alpha, - unlike the US large-cap market, it is not perfect.” Todd Ruppert, president and CEO of T Rowe Price Global Investment Services, echoes this view: “History has shown that a talented small-cap manager can outperform the Russell 2000 over time by a wide margin. It is difficult for large-cap managers, in the aggregate, to outperform their index, whereas for small-cap, the aggregate of managers can outperform”.
What is fascinating about this market is the sheer diversity of approaches to seeking alpha. Like the Amazon jungles that are characterised by a huge diversity of animal and plant species produced by an abundance of the key requirements for life, the large size and relative lack of research in the US small cap sector has stimulated a tremendous flowering of species of fund managers seeking to derive sustenance from this marketplace. The issue for a potential investor is what species do they think will succeed in this competitive jungle.
Structure of market
The US accounts for over 50% of global stock market capitalisation with around 6,500 stocks. Most attention is focussed on the largest stocks in indices such as the S & P 500 and the Russell 1000. The small cap sector is defined as the bottom 10% of the marketplace with the largest 2,000 of these incorporated in the Russell 2000 index leaving 3,500 not accounted for. As Chapman emphasises, “the US market is huge and the definition of small and mid cap companies includes companies that are large by UK and European standards and a mid-cap stock in the US could be very large by UK standards”. Indeed, the size of the US small cap market at greater than 5% of total world market capitalisation makes it comparable to any of the major non-US markets.
The behaviour of small cap stocks is very different from large cap. Chris Jones, from JP Morgan Fleming, an Englishman who crossed the Atlantic to spend the last eighteen and half years specialising in investing in US small cap, gushes enthusiastically that “the most exciting parts of the US economy are seen in US small cap. The dynamism of the economy is there!” This dichotomy between large and small cap performance is something that Ruppert elaborates on “when an organisation makes an allocation to US market, one assumes they are trying to gain exposure to the economic activity in the US. Smaller companies are much more domestically focussed. Large companies, by contrast, are not as directly reflective of the US economy since most have international operations”.
Indices and risk management
As in any specialised mandate, it is very important to understand whether an index benchmark is being used for performance comparisons, risk control or defining the universe for investment and not artificially constrain a manager’s options. The John Lewis mandate uses the Russell 2500 index although as Chapman explains “we were not benchmark constrained, and I am still debating what should be an appropriate tracking error target to reflect that”.
Preston Athey, a senior US small cap manager at T Rowe Price says of his clients: “Most use the Russell 2000 or Russell 2000 Value and Russell 2000 Growth. The S&P 600 is used by some and does make sense because the turnover is low and they choose institutional grade companies with good liquidity.” Whatever index is chosen, some managers like to exploit the ability to invest outside the index universe.
Philip Nash of Dimensional Fund Advisors (DFA), a semi-passive manager for example, state simplys “we hold most of the Russell 2000 plus another 1,500 stocks”, while Preston Athey comments that “in our small cap portfolios, we don’t buy much above the index; whilst the smallest stocks in the index have market caps between $150m (e122m) to $175m, we would go down to the $50m to $100m levels. They represent 15% of the names we hold”.
Risk control using the indices as a measure of minimum risk can be very misguided. As Athey points out that “the current weightings in the Russell 2000 Value index have 11.8% in REITs with banks at 11%. My personal belief is that it is not prudent to have greater than 10% in any industry. I have 7% in banks and 7% in real estate. I am underweight the Russell weightings but I prefer to be more diversified than be driven by what Frank Russell in Tacoma define as small cap!”.
Whilst the US large cap sector is seen as expensive, the valuation of the small cap sector as a whole is more favourable. Max Darnell of First Quadrant feels that the “US small cap 24 months ago was deeply undervalued. Small cap is no longer especially cheap relative to large cap, but it has not become expensive. That means that small cap should either keep pace with large cap, or should outpace large cap by a much smaller margin than it has this decade. If bond yields rise very sharply this could disadvantage small cap, but so far that pace has been more measured”. Jones, at JPMF, agrees “on a relative basis, small caps look fairly valued relative to large cap at this stage. The reason to invest in US small cap is that the historical rates of return have been higher than in other US equity categories, with higher volatility”.
Athey sees returns going in cycles as the graph shows with almost a sine-wave behaviour. “There are cycles of performance with a regression to the mean that reflects market psychology rather than fundamental valuations. You can observe what is happening and observe valuation levels. The graph shows 3-year lagging averages. Small cap is getting long in the tooth. If S&P went up by 10%, small cap may go up 15%, but if markets remained unchanged, small cap may underperform.”
The flowering of different species of fund managers in the US small cap jungle was evidenced in the final shortlist for the John Lewis mandate. Chapman explains that “the managers shown were very different from each other, including a very large manager of managers, a passive manager, a ‘mechanical manager’ (ie, active quant) and a couple of research-driven active managers. We were impressed by the range of managers, they were all very sophisticated.”
One key element that aids well-resourced institutional managers is that as Todd Ruppert points out, “in the US, there are a large number of retail investors” but in the small cap market “there is an imperfect flow of information”.
As a result institutional managers as a whole are outperforming retail according to Athey who adds “I own dozens of companies with no coverage or only one analyst”. An obvious approach to take advantage of the abundance of species of fund managers in this jungle would be to take a multi-manager approach. However, this can have the disadvantage of increased costs and “ would dilute the alpha potential” according to Chapman.
The small size and illiquidity of parts of the market makes even the simplest idea of passive indexation a much more complicated affair than in the large liquid markets. DFA a specialist in small cap fund management started as a passive house but as Nash indicates “returns and markets are moving us towards active management. We aim for 200bp on average over the Russell 2000. We get alpha from three areas: buying at a discount taking advantage of size.
“We have a huge inventory and can take in stock and be indifferent on its effect on the portfolio but can take the liquidity premium ie, can buy from distressed sellers; we take advantage of the effects of momentum in the marketplace by providing liquidity at the bottom of the market for stocks with modestly downward momentum; and we use filters to screen out deeply illiquid and deeply distressed stocks and also stocks that don’t reflect the asset class, eg, closed end investment trusts.”
The large number of stocks does, a priori, suggest that active quant methodologies could be successful and a number of players such as Axa Rosenberg, GMO and First Quadrant specialise in this approach, whilst JPMF offers active quant as well as a traditional approach. However as Darnell found out “we ran large cap since 19990 but it took a long time for people to feel a quant approach could add value in small cap”.
One problem that Athey points out is that “information is not updated as quickly as it could be. In the earnings season, there may be 300 companies that report on one day. It requires someone to input the data. When IBM or Microsoft reports, the data gets inputted immediately. For small companies it can take two or three days. If you use price information that is up-to-date but the data is old, you are getting the wrong information”.
For some, this can be a help in the small cap jungle. “The fact the data is frequently out-of date gives us some advantage in that the more noise there is in the data, the more opportunities there is to outperform” according to Darnell of First Quadrant. He points out that “there are two types of quant managers; those that are statistically based and those that are more theoretically based on fundamental ideas of finance.
The statistically-based managers “try and fill in as many factors as possible and put them into a model and you can get problems arising from data mining and low signal-to-noise ratios etc”. Needless to say, he sees First Quadrant’s approach as falling into the second camp.
JPMF’s quantitative approach is based on a proprietary multi-factor screening methodology that ranks the universe. As Jones explains: “Portfolios are constructed to a 300bp tracking error target and alpha generation for stock selection is driven by multi-factor signals. The process has a combination of value and momentum scores.” GMO also focus on value and momentum but split their portfolios into discrete value and momentum sub-portfolios to produce an internal multi-manager approach within a portfolio to reduce volatility.
In contrast, Darnell, argues: “What you don’t get from a multi-manager portfolio, is the shifting of risk from one investment style to another when the opportunity shifts from the former to the latter.” First Quadrant “uses simple models behind market inefficiencies” and sees its niche in the jungle as utilising its “skill in taking the right balance and shifting between the factors. We call it style tilting. We look at the economic environment, whether stock prices are cheap, which way interest rates are changing, if they are rising, it is a better environment for value stocks etc. In these market conditions, which kinds of style will do well. If conditions change quickly, we can be behind the curve although in the long run, we will catch up”.
T Rowe Price, with over $20bn in small and mid cap US stocks, is a good example of the mega fauna in the small cap jungle with a heavy emphasis on fundamental research. As Preston Athey describes it: “We have 30 senior domestic analysts, each one following an industry or group of industries. I believe quant screening in this area is not very effective. If you are just using screening to get a selection, then we are better off using 30 analysts who are experts. Most successful small cap managers do that.”
He sees the ability to understand a company in detail as key to their success: “The smaller the company, the bigger the insights you get from company visits. Interviewing Bill Gates may not give many new insights but when you own 8% of a company and you visit them, you see not just the CEO, the CIO, but also sales staff, suppliers, other staff in the company car park. We can ask questions such as, for instance, why they made an acquisition two years ago? If management just wants to be big and they don't mention profits or return on capital, then maybe they just want to be big and you don’t want to be in that company”.
The ability to utilise both quantitative and qualitative information can be exploited to look at quite complex small companies by research- focussed managers. Athey enthuses that “one company for example, is in South Dakota, in four to five different businesses, – agricultural electronics using GPS to plough fields in straight lines, weather balloons and a couple of others. It is extremely well managed, with a high return on capital. However, the management doesn’t go around marketing.”
Owning large stakes of as much as 15% of a company means that, as Athey jokes:“You are not just a stockholder, you are a ‘stuck holder’”. This is analogous to private equity investment issues but one distinction is that “we don’t try to influence management – under SEC rules we would have to file as ‘active investors’ as against passive investors. We give advice but don’t try to control companies”.
Jones at JPMF is trying to take the best of both worlds by using the quant process from the JP Morgan side of the recent merger to act as an input for the traditional approach favoured by the Fleming team. “We take the quant scores from the quant models and our research analysts take the top two quintiles and six dedicated small cap analysts cover every stock in the Russell 2000 Growth. Our active process has not changed a lot and we have used it for the last 15 years. We used to have a lot of different screens but in a less disciplined fashion than now, when we are using the JP Morgan screens. The other thing that has been added is the discipline of risk management.”
An example of one of the successful smaller and highly specialised animals in the jungle is Friess Associates, who only manage US growth stocks with $1.5bn in small cap out of a total of $7.5bn. As Gordon Kaiser explains, its strategy is to “focus on strong earnings growth relying on fundamental analysis. We surf for earnings growth of 20% over the last year. We buy at a reasonable price of no more than a forward P/E ratio of 20-25 times. We use our own internal models and compare with Wall Street analysis and decide where they are wrong”. They have 27 researchers and “each day, the researcher follows 8 to ten stocks and ranks them in order. If a stock is seen as having a 40-50% upside, it will replace something else”.
In contrast to T Rowe Price, where with a turnover figure of 10-15% in the portfolio of around 260 stocks, - the stocks would be kept on average for 7-10 years - Friess has portfolios with typically 120 stocks with a 250% turnover, implying they are kept for less than five months on average. “What we are interested in is earnings acceleration. One of the reasons we sell a stock is that we can’t find another reason for earnings growth that the Street hasn’t found. We sell for three reasons; we have hit our price target; we catch word that the fundamentals are deteriorating; or we come up with a better idea.”
The US small cap market is interesting because it is large, under-researched, and reflects the domestic economy of the US far more than the US large caps which account for the vast bulk of market capitalisation. Finding a manager is not always easy however, as successful managers invariably have to close funds for new investment. As Todd Ruppert explains: “Our small cap funds are closed to new investors as we don’t wish to dilute returns for existing investors for the sake of marginal revenues.”
New European investors to the market are therefore facing the choice of either going for a broader universe from an established player with a closed small cap capability, eg, a small and mid cap mandate from a firm like T Rowe Price with a Russell 2500 benchmark, or of finding a good small cap player who has capacity available.
However, whilst the small cap jungle has many species of fund managers, as Jones points out: “Buying into a top-performing small cap manager can be a dangerous thing to do, as it is difficult to sustain performance.” So, like the Amazon jungles, there are many riches available but avoiding the dangers is not always easy.